The equity markets were caught wrong-footed by Brexit. Some valuations dropped sharply but that is seldom reason enough to buy. As we return to fundamentals, in this article we will review the credibility of consensus earnings prospects. We will focus on some sector biases which are highly instructive.
The surprise victory of Brexit caught the markets off guard. After much hesitation they suddenly rallied a few days before the election. From 16 to 23 June – i.e., from the murder of Jo Cox to the referendum – the MSCI EMU and UK both gained about 7%, plus another 5% by sterling. Many investors were ultimately caught wrong-footed by the outcome of the referendum, triggering a sudden drop in risky assets and a retreat into “safe havens”, like sovereign yields, the yen, the Swiss franc, the dollar and gold.
On Monday 27 June, at the peak of the crisis, the MSCI EMU and UK were down, respectively, by 11% and 6% vs. 23 June, and sterling had lost more than 11%. Since then, the equity markets have clawed back some of their losses. One week later, on 4 July, the MSCI EMU was down “just” 5% compared to 23 June, the MSCI Europe was almost unchanged (-2%), and the MSCI UK was even up +3% (see chart 1).
So the situation appears to be stabilising, but things are not so simple in reality. While US and emerging markets indices held up very well, Europe markets diverged. Switzerland and northern Europe fared well, but the euro zone was hit hard, especially on its periphery. The performance of the MSCI UK is misleading, as sterling is still down 10% vs. the USD. As a reflection of the persistent anxiety, “safe havens” are still trading strongly. Sector performances are also highly revealing of the prevailing malaise. For example, the MSCI Europe limited decline (-2%) masks the huge divergence between energy (+7%) and defensives (+4%) on the one hand, and cyclicals (-4%) and financials (-13% in Europe and up to -25% in Italy) on the other hand. In other words, return to calm is far being the case for the entire market, and divergences are still wide from one country or one sector to another.
Don’t try to catch a falling knife. The valuation of a market – unless it has bottomed out, which is not currently the case – is seldom reason enough to buy. We therefore continue our review with an assessment of earnings forecasts, focusing on sector outlooks, as they are very uneven and therefore highly instructive.
Let’s start our comparison in late 2007, before the financial crisis peaked. Since then, EPSs have risen by 32% in the US while falling 46% at the same time in the euro zone. Between these two extremes are Japan (-6%), emerging markets (-20%), and the UK (-26%).
The main reason that the euro zone is so far behind the rest of the world is that it has experienced two recessions during that time, vs. just one for the other regions. Another reason is that the euro remained very strong for a long time, which squeezed EPSs, as expressed here in local currency (with the exception of emerging markets in USD). From one region to the next, sector weightings are very different, which can also skew comparisons. For example, the US was driven by the momentum and weight of its tech sector (20% of the MSCI US vs. just 4% in Europe), whereas the euro zone has suffered from he difficulties of financials and utilities (respectively, 19% and 6% of the MSCI EMU , which together account for 25% of the index.
More recently, since July 2014 there has been a shift in trend in the MSCI World AC, with, for the first time since the financial crisis of 2008, a prolonged decline in EPSs (see chart 2).
While this decline is nowhere near as great the drop of 2008, it is comparable in duration. As in 2008, the decline is not restricted to one or two regions but has been almost universal. For example, with the notable exception of the euro zone, which has rallied tentatively over the past few months, the other regions
have seen a steady decline in their EPSs – the UK since August 2012, emerging markets since September 2014, the US since October 2015, and now Japan since April 2016.
As to the reasons for this decline, slower global economic growth in 2015, particularly in emerging markets, may have played a role, but a secondary one, given the limited drop of Emerging EPSs in 2015 (-7%) and their low weighting in the indices (11% of the MSCI World AC). However, with the collapse in commodities prices, sector aspects have played out in full.
For example, within the MSCI World AC, 2015 EPSs in basic materials and oil fell, respectively, by 26% and 54%. These sectors each account for 5% and 7% of the index. All other factors being equal, the drop in their EPSs accounted for roughly 500 basis point drop. In other words, apart from these two sectors, instead of falling 3%, 2015 EPSs of the MSCI World AC would have continued to rise by about +2% (see chart 3).
If this sector impact was decisive in 2015, what about now? For the current year and the next two, the IBES consensus of analysts is for an EPS growth of +2% in 2016, +13% in 2017 and +12% in 2018. While no one is surprised by the weak 2016 numbers, the projected acceleration beginning in 2017 looks surprising. The US cyclical recovery has already reached its asymptote by far; there are new threats in Europe since Brexit; Abenomics and the yen’s depreciation have petered out; and the Chinese engine is having a hard time maintaining speed.
For a better assessment, a view of sector contributions is once again highly instructive. For example, the almost doubling of EPSs in energy in 2017 is expected to contribute as much as 700 basis points. In other words, the +13% gain in EPSs of the MSCI World AC in 2017 is expected to come mostly from this one sector and, to a lesser extent, to the recovery in basic materials and financials.
However, such an uneven increase in profits does raise many questions, as a recovery on such a narrow base looks shakier and, above all, unlikely to be self-sustaining. While a sharp upturn in energy and basic materials in 2017 is highly plausible, given their low starting points, this will be less the case in 2018. Similarly, in light of negative interest rates, the economic, political and regulatory environment, as well as the market environment, visibility on financials remains very low.
Regarding the energy sector, our baseline assumption is that oil prices should level out in a range between $50 to $55 over the next 18 months. They had fallen four-fold from June 2014 to January 2015 (from $114 to $28) but have begun to make up this lost ground. Our 12-month rolling comparison, thus far highly unfavourable, should become less demanding early next year. Against this backdrop, between more favourable price effects and lower exceptional charges, the sector’s results, while not doubling, should be much better. However, for 2018, barring a true improvement in the economic environment and further gains in oil prices to about $65-70, a new 38% rebound in the energy sector and, hence, a +12% rebound in MSCI World AC earnings seems unlikely. To say nothing of financials, where visibility is lacking.
After this global overview, let’s take the same approach to individual regions.
In the euro zone, the consensus expects earnings to be up slightly in 2016 (+2%), followed by a steep acceleration thereafter (+14% in 2017 and +11% in 2018). As with the MSCI World AC, these earnings will also depend mostly on energy and basic materials (a delta of +510 basis points between 2016 and 2017), as well as financials. According to IBES, after squeezing 2016 results, by 6%, or 130bp), financials could turn up in 2017 by 15%, or 370bp. However, as the euro zone is being hit especially hard by Brexit fallout and negative interest rates, visibility on the sector is quite limited. With more than half of the euro zone’s non-performing loans, Italian banks are at the epicentre of the crisis. How those NPLs are address will be key, and this is an issue that Europeans are currently divided on. With the findings of the ECB’s coming stress tests due out on 29 July, this issue should play out in the coming weeks and will be decisive in assessing the sector’s earnings forecasts.
In the United States, after +1% forecast for 2016, it may also seem strange for earnings to rebound so strongly in 2017 (+14% forecast), as they have clearly been in an expansion cycle for a long time. But in the US, more than elsewhere, the rebound is mostly an optical illusion. While the US oil sector has almost the same weighting in the indices as in Europe, it is far more upstream and therefore was hit harder by falling oil prices. Conversely, beginning in 2016, it is likely to benefit more from higher oil prices, with energy’s contribution to stronger US earnings leaving the other sectors behind.
Conversely, in Japan, energy is very lightly weighted in the indices (less than 1% of the MSCI Japan). So it will have only a tiny positive impact on 2016 results. This raises a red flag on the +15% global consensus forecast. A closer look finds that it makes big assumptions on a strong improvement in industrial and IT sectors. Given the JPY’s year-to-date gains (more or less 20% vs. the USD, the EUR and CNY), we are somewhat sceptical.
In emerging markets, sector biases are actually rather balanced. Like elsewhere, a significant improvement is forecast in earnings in 2017 in energy, basic materials and finance, as well as in industry and IT. In ther words, this improvement would be broad-based. This encouraging scenario would be consistent with expectations of relief for commodities-exporting countries and relatively accommodating financial conditions, given the only minor tightening - if any- expected from the Fed and a decline in risk aversion.
In conclusion, when looking at future earnings, as the means used are misleading, a sector-based assessment has become essential. Globally, given the fallout from the commodities crisis, EPSs of the energy and basic materials sectors will play a key role in the rebound in 2017 but with no guarantee that it will stay as strong in 2018. Regionally, in the euro zone, while the commodities component of the 2017 earnings rebound is not at issue, the strong increase forecast from financials is less certain (due to Brexit fallout, negative interest rates, how the Italian crisis is dealt with, etc.). In the United States, the possibility cannot be ruled out of surprisingly good 2017 earnings, but this would be mostly an optical illusion, skewed by the expected tripling in energy sector earnings. And in emerging markets, earnings growth seems rather well balanced, which would be a good sign for their sustainability.
Earnings sector biases are highly instructive