Earnings are among the key factors driving the performance of single stocks and the overall market. They are a proxy for value generation in the listed corporate sector and, consequently, earnings growth typically has an overriding impact on the performance of stocks and equity indices.
For this reason, the quarterly reporting season, when companies not only present their achieved results but also tend to provide hints or even guidance on management expectations for the near future, is such a big event.
The current earnings season is even more important than usually because after the massive correction in the fourth quarter of 2018, market participants need to understand whether the sell-off was caused by a change in investors’ aggregate risk assessment (i.e. higher discount rates) or by a deteriorating earnings outlook (although these factors often cannot not be completely separated).
Here are some of the trends that have emerged in the course of the ongoing reporting season:
1. The current earning season is better than expected (or should we say “feared”?)
In the US, by mid-February, close to 80% of the companies had reported and more than 70% of the companies reported better earnings than expected (according to Bloomberg consensus) and 60% beat the top line forecasts. Both figures are decent but worse than in the previous quarter.
In Europe as well, positive surprises dominate so far. Of the companies that have released their 4Q results up to mid-February, more than 60% reported better top line figures and 56% beat earnings forecasts. These may not be outstanding figures by historical standards, but they are clearly not particularly worrisome and, unlike in the US, they are even slightly better than in the previous quarter.
2. But note: the bar has been lowered ahead of the reporting season.
While the ratio between positive and negative earnings surprises looks solid at first glance, it should not be overlooked that earnings expectations for the final quarter of 2018 have been cut ahead of the reporting season. In the US, the forecast for 4Q index earnings drifted 2.9% lower during the quarter, and in Europe 4Q earnings forecasts were revised down by almost 12%. Apparently, the sell-off in the fourth quarter and the global growth slowdown triggered substantial downward revisions of earnings expectations. The revisions turned out to be overdone – – considering reported results – but it has to be noted that without these revisions, there would have been – on average – no positive earnings surprise in the US and a negative surprise of almost 10% in Europe.
3. Growth has slowed in Q4
In the US, average annual EPS growth has slowed from 24% in 3Q 2018 to c.11% in the final quarter of last year and in Europe from 9% to 2%. On the revenue side, the picture looks somewhat better: In the US, sales growth decelerated just 1.5 percentage points to c.8% and in Europe top line growth came in even slightly higher than in 3Q.
Three points are noteworthy: while growth has slowed it is important to note that there was still growth in the fourth quarter. Second: the US corporate sector continues outgrowing its European counterpart in terms both of aggregate revenues and of earnings – which is just another confirmation that the macroeconomic background is still stronger in the US than in Europe. Third: margins improved in the US (no surprise, given the impact of the US tax reform) but contracted in Europe.
4.Expectations for 2019 are still positive but risks are skewed to the downside
The outcome of the ongoing reporting season has failed so far to end the downward trend in earnings forecasts for the current year. Recent forecasts of 2019 index earnings for the S&P 500 and the Stoxx 600 are 5-7% below their peaks in the second half of 2018.
As a result, both for the S&P 500 and the Stoxx 600 universes, earnings growth estimates for the full year have come down from the high single-digit range to around 6%. However, downward revisions do not seem to be over, and I expect the growth consensus to settle closer to 3-4% after the reporting season is over.
Note: A consensus estimate is a figure based on the aggregated estimates of analysts covering a field or sector.
Overall, the main implication for investors is that – after two years of strong growth – corporate earnings will most likely not act as an upside trigger for US and European equities. While downward revisions seem to have slowed as of late, risks to corporate earnings are clearly skewed to the downside. Global economic growth continues decelerating, while wages and other cost-factors are climbing higher. It is not obvious that these developments are fully reflected in the margin assumptions of sell-side estimates.
However, there is no reason to be overly gloomy, because a) current estimates do not suggest that investors will face a collapse in earnings, and b) expectations have already been cut significantly. For example, current consensus forecasts are already taking into account that 1Q 2019 earnings will most likely shrink year-on-year on both sides of the Atlantic. Investors do not seem to be infected by an overdose of optimism at present – which in itself is a reason for moderate optimism.
Prognoses are no reliable indicator for future performance.