CIO Weekly - First Quarter Earnings

WHAT YOU NEED TO KNOW

• First-quarter corporate earnings in the US and Europe were slightly better than the market expected. However, the percentage of companies beating expectations was the lowest since the global financial crisis
• There was significant dispersion across sectors, which translated into divergent regional performance. A powerful reminder that sector composition matters when assessing the prospects for regional equity markets
• We remain moderately overweight equities, with a clear preference for information technology and healthcare. Regionally, this translates into a preference for US equities and emerging market equities over their European counterparts

Q1 EARNINGS SEASON
In this note, we review the first-quarter earnings season in Europe and US and its implications for our asset allocation positioning.

EARNINGS
With over 70% of companies having reported in the US and in Europe, earnings in the first quarter are down yearover-year (yoy) by approximately 8% in the US and by 21% in Europe.

The approximate 13% earnings outperformance yoy of the US versus Europe is similar to the trend of recent years.

The main reason for the divergent performance is the difference in sector composition. For example, information technology accounts for 22.7% of corporate profits in the US, compared to just 2.6% in Europe. European companies have also been hit harder as Covid-19 containment measures typically started earlier than in the US.

SALES

Sales in the US surprised positively, up 1% yoy thanks to strong performance from healthcare, information technology, and consumer services companies. Sales growth was worse than expected in Europe, down 7% yoy, with the biggest declines coming from the energy, utilities and consumer goods sectors. Europe has little exposure to more resilient sectors, such as information technology and consumer services. Instead Europe has higher exposure to “old economy” sectors that are being been hit harder in the economic slowdown, such as the automotive subsector within consumer goods. The main reason for the divergent performance is the difference in sector composition. For example, information technology accounts for 22.7% of corporate profits in the US, compared to just 2.6% in Europe. European companies have also been hit harder as Covid-19 containment measures typically started earlier than in the US.

SURPRISES

Perhaps the biggest surprise came from the energy complex, which beat analysts’ expectations both in the US and in Europe. In our Counterpoint Weekly dated 20 April, we upgraded our view on the energy sector from underweight to neutral. The healthcare sector was among the top performers during the market rout last quarter, and this outperformance continued with companies generally beating analysts’ expectations. We believe the sector remains well positioned to perform short-term amid Covid19 uncertainty and is supported by long-term secular trends. The financial sector’s recent poor performance during the sell-off, as well as in the rebound, indicates that the market thinks the sector is set to suffer large losses. Most banks reported results below analysts’ expectations, which did little to alleviate market concerns. It is encouraging that banks could be viewed as part of the Covid-19 economic solution, with potential benefit coming from more lenient regulators. However, loan losses may once again prove challenging, despite the strongest capital ratios in the last 20 years.

LOOKING AHEAD

Equities are a long-duration asset, with earnings projected into perpetuity. A singular quarterly earnings season should not impact equity prices materially. Nevertheless, it is notable that, while earnings expectations for 2020 are still being revised lower, the pace of downgrades has diminished. If we look beyond 2020, we see analysts expect a normalisation of earnings growth, with 15% cumulative earnings growth expected between 2020 and 2022 in the US, and 10% in Europe. You can also see the first positive change in forward three-year earnings growth expectations, with a slight uptick in the European expectations.

If we take earnings estimates for 2020, then one-year forward price-earnings (P/E) ratios look expensive in the US (22x) and in Europe (18x) compared to history. However, with a longer-term horizon, at current market levels, three-year forward P/E ratios look reasonable compared to history, at 15x for the US and 12x for Europe. Granted, equities are not cheap, but in a context of low interest rates, assuming growth rates stay constant or improve, then equities have more to offer.