Earnings growth returns, but for how long?

US equities and past precedent

The S&P 500 is smashing through previous record highs on a near daily basis. The year-to-date performance so far is 5%, double that of the FTSE 100. One reason for the latest leg in this multi-year equity market rally is earnings. The fourth quarter of 2016 picked up strongly from the third, which broke a year-long spell of outright contraction (figure 1).
The strong tailwinds in the US and global economy are clearly translating into an increasing ability for corporates to grow their profits. However, we note that heightened expectations led to fewer companies than usual beating forecasts (figure 2). To date 428 companies have reported their earnings of a total 505 – 85% of the total companies in the S&P 500.

Stretched valuations

Nevertheless, while US companies are clearly doing better on aggregate, valuations are stretched. The cyclically adjusted price-to-earnings ratio – a measure of current prices in the context of the business cycle – is elevated, at 28.3, well above the long-run average of 17. This is a risk for two reasons. First, equities tend to produce below-historical returns from positions of above-historical valuations. Second, the risk of a sharp sell-off is also heightened when valuations are elevated.

Much of the recent momentum in US equities was driven by the election of Donald Trump as president in November 2016. Many investors appear convinced huge US infrastructure spending and slashed taxes will bring about President Trump’s “guaranteed” annual economic growth of 3.5%. However, there are strong reasons why this may not happen.

The anticipated level of growth has not been achieved in the US for more than a decade, and wildly pumping fiscal stimulus into the economy will do nothing to address fundamentally poor demographics or slowing productivity. Moreover, higher-than-expected inflation may cause the Federal Reserve to raise rates sooner than expected, which would act as a headwind to the economy and corporate earnings.

On balance, we believe our underweight exposure to US equities is warranted in a global equity portfolio.


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