Is Q4 earnings optimism misplaced?

In a highly uncertain macroeconomic and geopolitical backdrop, the fourth-quarter (Q4) earnings season is of particular importance. Indeed, with developed equity markets’ valuations reaching levels not seen since the “dotcom” bubble twenty years ago, we believe that stocks need improving fundamentals to sustain their march higher.

Another low bar

At face value, expectations again appear low with analysts forecasting that US companies, on aggregate, will deliver next to no earnings growth in Q4. At the sector level, alongside US financials – most of which have already published much better than anticipated results – utilities are expected to report double-digit growth. On the other hand, energy and materials will likely see earnings decline on the back of weak commodity prices (versus the same period last year).

While slightly more encouraging, the picture in Europe is not bright either, with growth of just 2% expected for the region’s 300 largest companies. There, the technology and telecommunications sectors are likely to drive earnings higher.

Mind the gap

Although we expect to see a very modest year-on-year increase in earnings, the fourth-quarter’s results should leave full-year 2019 growth close to flat in the developed world. This is in stark contrast with the 25%+ returns experienced by equity markets over that period.

The divergence between actual results and buoyant share prices is linked to investors’ belief that 2020 will see a sharp rebound in activity. The combination of receding trade tensions, accommodative central banks and a lack of inflationary pressures are powerful tailwinds for both the top and bottom lines of most companies. In fact, these hopes appear so prevalent that we would not be surprised if investors were willing to give management teams the benefit of the doubt even if Q4 results disappoint.

Limited room for error

While, in light of the very recent positive development on the trade front, investors may give company management the benefit of the doubt, this is likely to be case only if forward guidance remains positive. Indeed, equity markets are already factoring in high single-digit earnings growth for 2020. Assuming that profits expand by mid-single digits only, then global developed equities are trading at a price-to-forward earnings ratio of around 18.5, a level last seen just before (and after) the 2000 tech-led bubble. Shares can, from time to time, decouple from fundamentals but this tends not to last forever.

No crash but volatility ahead

Admittedly the world has changed a lot in 20 years. Other than elevated equity valuations – which can be justified by ultra-low interest rates – we see no parallel between what happened in the early 2000s and what investors face today. Indeed, we see no signs of “irrational exuberance” yet, the vast majority of companies are highly profitable and central banks are far from tightening monetary policy given the inflation outlook.

As such, we continue to see equities as one of the most attractive asset classes over the medium term. But we also recognise that markets do not go up in a straight line and that the current backdrop leaves valuations prone to bouts of volatility (as already experienced this year).

Be mindful, not fearful

We reiterate the key message from our Outlook 2020: staying invested remains the most suitable course of action for long-term investors. But appropriate diversification and risk management will be paramount to protect and grow capital this year.

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