20 May 2018
US companies had an excellent beginning to 2018, as shown by their strong first-quarter corporate profits. European businesses, on the other hand, had a less auspicious start, a fact also reflected in their earnings reports. Given the economic background in each region (tax cuts and a weaker dollar in the US and a surprise slowdown in activity in Europe), neither of these facts is particularly surprising. Rather, it’s investors’ response to them that has left commentators scratching their heads.
A couple of weeks ago, we looked at the extremely high hopes for this US earnings season and questioned whether companies could live up to them. The ratio of upward versus downward revisions to company profits was at an all-time high, even more elevated than in Spring 2009 when recovery from the global financial crisis was just getting under way. Unusually, analysts kept making their projections higher as earnings season began. More commonly, they lower the bar as the season starts, artificially inflating the percentage of companies that can be said to have ‘beaten expectations’.
It seems that US companies have met expectations and more. At the time of writing, 91% of companies in the S&P 500 Index of large US companies have reported their earnings. Of these, according to data from Thomson Reuters, 78.5% have beaten forecasts, while fewer than 14% missed the targets set for them by analysts. The long-term average (since 1994) for US earnings ‘beats’ is 64% of companies. More recently, it has moved up to 75% but this season is still exceptional. Nor were the earnings outperformances confined to one or two sectors but were widespread across all areas of the market. On average, those companies that beat earnings per share (EPS) forecasts did so by a respectable 6.8%. However, for the economically-sensitive industrial and consumer discretionary sectors, this figure rises to a whopping 11%. In short, the US season completely surpassed expectations, which were already high to start with. Despite this, investors in US equities seem underwhelmed, with the S&P 500 Index relatively flat throughout the reporting season.
Source: ASR Ltd, Thomson Reuters Datastream, 16 May 2018. Past performance is not a guide to future results.
It’s a different picture in Europe. Traditionally, European earnings season is often treated as something of an ‘also-ran’ versus its US equivalent, particularly as public companies in the European Union are not legally required to make reports every quarter, although many still do. This lack of attention may go some way to explaining investors’ seemingly at-odds response to the news but it is not the whole story.
In contrast to the US, expectations were low for growth in European first-quarter company profits and analysts pared them back still further ahead of the reporting season. This lowering of forecasts in Europe was likely a result of two things. First, there was a moderation in the region’s economic activity. In our opinion, though, some gauges of European economic activity, such as purchasing managers’ indices (PMIs), had been at unsustainably high levels. They were subsequently negatively affected by events such as extremely bad weather (the ‘Beast from the East’) and a ‘flu epidemic’ in Germany. Second was the strength of the euro. European indices contain many exporters. A stronger euro means that products from these companies become less internationally competitive and, moreover, their foreign earnings are worth less. These factors have negative consequences for company margins.
This may go some way to explaining why the number of positive earnings surprises in Europe is at its lowest for two years, despite analysts having lowered the bar before the reporting season began.
But despite this fairly dismal performance, European equity indices are up. The Stoxx 600 Index has gained over 7% since companies began reporting in early April:
Source: UBS, Thomson Reuters Datastream, 16 May 2018. Past performance is not a guide to future results.
There are several reasons for the dichotomy in investors’ responses to the two earnings seasons. First, those in Europe likely believe the factors that have recently weighed on economic activity to be one-off events, meaning a recovery in both the economy and corporate profits could be in the pipeline. The latter now have the benefit of a low starting point. On the contrary, US companies are much higher on the grid: in 2018, there has been a 20% year-on-year increase in EPS, leading to fears that they have reached ‘peak earnings’. While we think that this is unlikely, we do believe that growth in the US corporate earnings has peaked.
In addition, events in the US are evidence that investors are looking beyond the surprise factor in corporate earnings – the ‘beat by a penny’ game (where investors are attracted to any company that has beaten forecasts, even if only by very small amount) may be dying out.
Currencies have also played an important role. The weak dollar was very beneficial for US company profits, while the euro’s strength against its international peers had the opposite effect in Europe. But things are changing on the currency markets: it now seems the dollar is no longer weakening against the euro and sterling, making shares of US multinational companies look less attractive and their European-based equivalents more appealing.
The future direction of currency moves may determine the relative performance of regional indices but it’s worth taking into account the fact that there has already been a sharp sell-off in global equity markets this year and shares in many large companies look attractive. By this token, investors are likely to welcome an increase in company profits, particularly in Europe, where there is now scope for substantial improvement.
Karolina Noculak is Investment Strategist, Multi Asset for Aberdeen Asset Management
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