Global Summer Earnings Preview: Sizzle or Fizzle?
Overseas markets generally had strong earnings last quarter, with energy companies providing the biggest boost.
Future expectations are high once again for energy companies, but also for consumer and financial companies.
Structural changes may be happening in France that could positively impact the environment for corporate profitability.
GLOBAL SUMMER EARNINGS: SIZZLE OR FIZZLE?
Can overseas earnings continue to grow and extend the first-half rally in many international markets? That is the question investors are asking as second quarter 2017 earnings season begins. Since the financial crisis of 2008, U.S. companies and equity markets have generally outperformed their overseas peers. Greater U.S. profitability and corporate efficiency have resulted in stronger earnings growth, and domestic equity markets outperforming overseas ones. That may be starting to change, as earnings growth is improving overseas and international markets are outperforming domestic market indexes.
EARNINGS IN FOCUS
Now that Europe is past the potentially upsetting elections in the Netherlands and France with little volatility, the market will be focusing on earnings. European corporate earnings had been weak until the fourth quarter of 2016, which continued the trend of strong fourth quarters, even in weak years [Figure 1]. Despite a strong finish in 2016, for the year European corporate earnings had declined -5.4% in U.S. dollar terms. Unlike in other years, earnings started strong in 2017, with annual earnings growth of 15% through the first quarter of 2017. Expectations were high, and 62% of companies outperformed expectations, far better than recent performance. The single largest contributor to growth came from energy companies, which benefited from the rebound in oil prices over the past year. Other sectors also showed strength, with earnings improvements in basic materials, consumer companies, as well as financials.
Expectations for the future remain high for European earnings growth, forecast at 9.1% for the second quarter of 2017. Even excluding the expected boost from energy, analysts are still forecasting 6.1% growth. As with last quarter, consumer companies and financials are also expected to grow. The biggest change is expected in European industrials, which had flat earnings last year and declining earnings in the first quarter of 2017. Investors are hopeful that the strong manufacturing data in Germany and France will translate into better company bottom lines.
Emerging markets (EM) are also expected to continue a trend of strong earnings growth in the second quarter. Consensus market forecasts for the quarter are for earnings growth of 9.1%, the same figure as European estimates. Overall estimates for 2017 are calling for 22.2% growth. Furthermore, as is the case for European companies, estimates for the year had been rising. This has been especially true for important sectors like energy and technology. Within technology there has been an increased focus on Chinese “new technology,” which relates to firms that provide internet connectivity or use the internet to sell goods and services.
Historically, when examining geographic regions, asset allocators would focus on the relative strength and weakness of the different countries in that region. While we still look at individual countries, increasingly we have been focusing on sector allocations within and across regions. The equity markets have become more globalized with less focus on country-specific issues. Sectors like energy or materials always had a strong global component; a change in the price of oil, copper, or any other commodity generally impacted all the companies in that industry the same way, regardless of where the company was located.
More recently other sectors, such as financial services, are becoming increasingly globalized. The relative health and performance of an industry like banking used to be dependent primarily on local factors such as interest rates and regulations. But today, these factors are increasingly global. Decisions made by a major central bank may have implications for banks in countries around the world. Technology has changed as well, with emerging and developed market companies both supplying to and competing with each other.
Markets today have different compositions [Figure 2] and therefore respond differently to global economic factors. For example, technology is an important part of the U.S. and many EM economies and stock markets, but is a relatively minor part of the European market. With the large allocations to the technology and consumer discretionary sectors, in some ways the U.S. market more closely resembles EM.
THE FRENCH TWIST
European companies typically have lower levels of profitability and efficiency when measured by metrics like return on equity. Part of the reason for this is government policies related to taxes and labor regulations. For example, France has a 35-hour work week. While designed to allow for more people to be employed, in practice this becomes cumbersome for employers and ends up being a disincentive to expand hiring. The French retirement age is 62 years old, with a complicated formula for determining pension benefits upon retirement. For most of this century, Germany was the economic leader of Europe, with most other countries being considered second tier. At times this has created tremendous political friction between Germany and some of the other countries, and can be seen as weakening the European Union as a political force.
The French elections this spring resulted in Emmanuel Macron winning the presidency, with the subsequent victory of his En Marche! party in parliament. Macron has promised significant tax, labor market, and other reforms; so much so that a number of commentators have suggested that Macron might be the French Margaret Thatcher, or even the French Ronald Reagan. By any measure, those would be ambitious comparisons, especially given the strong student and labor movements in France. If he is successful in getting his reform package enacted, the election may mark a sustained turning point in French corporate policy, the performance of French companies, and maybe even how U.S. investors view French stocks.
It is highly beneficial for the global economy to see Europe begin to accelerate growth in its economy, as well as in corporate profitability. Should the growth trend continue in 2017, it may impact not only European equity markets positively, but also stocks globally. Certainly the equity markets are expecting both Europe and EM to continue to show strong earnings growth across a number of different sectors. Investors are also looking to see if France can prove to be a more structurally favorable investing environment. If these positive developments continue there will be a broader range of options for global investors.