US and European earnings trends: Better to travel than to arrive

While political volatility may be on the increase, consensus profits forecasts have in contrast remained on a stable trend over the second half of 2016. In the UK, 2017 forecasts have now recovered their modest post-Brexit drop, in part due the positive impact of the decline in sterling. US estimates for 2017 have also only fluctuated in a very narrow range during the last six months. In continental Europe the post-Brexit declines have stuck and there has been an additional modest decline in forecasts during October. This period of relative stability in earnings forecasts is in sharp contrast to the significant declines which spooked investors for much of 2015 and Q1 2016.

Exhibit 1: Stable trends in consensus earnings forecasts

The relatively strong correlation between sector returns over short investment holding periods of less than a year and consensus earnings revisions is a phenomenon which investors should trade to their advantage as the relief rally in equities since earnings forecasts stabilised has been significant, Exhibit 2.

Exhibit 2: US and European equities – from oversold to overbought on inflection in estimates?

We believe it is now time to reduce what were as recently as earlier in the year contrarian overweight exposures to commodities, commodity equities and energy. The improved short-term outlook for the UK mining sector appears to be largely discounted – 2017 forecasts have been revised up by 50% since February while the sector has doubled in price, Exhibit 3.

Exhibit 3: 50% rebound in earnings forecasts discounted by 100% gain in UK mining sector

It has therefore been a difficult year for bearish funds which may have rediscovered that the market can remain irrational for longer than an underperforming fund can retain its clients. We do in fact concur with the medium-term analysis that the golden era for commodity markets has passed and there are also significant risks to global markets in general. Median equity valuations remain high, while economic growth sufficient to support the weight of debt now burdening the global economy remains elusive.

However in February when the fears of a commodity collapse were running in full flood markets had become too quick to discount hard landing scenarios in the sector. In the event, a surprise surge in credit growth in China combined with a recovery in oil prices from oversold levels has already lead to one of the largest commodity equity rallies since the 1970s, outside the go-go years of mid-2000s.

This rally does not however prove the bears ‘wrong’, nor the bulls ‘right’. The arguments for a cautious view on listed markets globally remain in place, even if for now earnings estimates are stable. Developed market price/sales and price/book valuations remain at unappealing levels in a historical context. Furthermore, we believe the combination of a Clinton victory in the US Presidential election and rising headline US inflation may embolden the Fed to continue on its path of gradually raising interest rates. In this respect, the recent Fed focus on r* (a lower long-run real interest rate) and adverse demographics reflects a long overdue reset to earlier market expectations rather than a renewed dovish shift in our view.

As we have written previously, we believe the high watermark for monetary policy may have passed and policymakers’ attention is turning to fiscal policy to support growth. The era of pushing up asset prices (a.k.a. reducing risk premia or the cost of capital) to stimulate growth may therefore coming to a close, even if the timing may be protracted.

Quick conclusions

1. Consensus earnings forecasts remain relatively stable in the UK, US and continental Europe.

2. In the UK post-Brexit declines in earnings forecasts have been fully recouped, unlike continental Europe where there has been a gentle drift lower.

3. Investors should not overstay their welcome in commodity and energy sectors; we believe it is time to scale back contrarian overweight holdings.