The US equity market is an enigma. In Jan/Feb, against a backdrop of extended equity valuations and signs of a further slowdown in global economic growth, US equities suffered a violent 11% fall. In an amazing recovery, the S&P 500 recovered its entire losses in eight weeks. This follows an almost identical 12% meltdown and miraculous rebound in July last year due to similar valuation fears. On both occasions, the majority viewed the corrections as the start of the long-awaited US equity bear market.
Similarly, after a 5.5% fall following the “Leave” vote in the UK referendum, US equity markets have fully reclaimed the Brexit losses in yet another spectacular “V” shaped recovery. Like the bear market predictions, which followed US corrections, the Brexit sell-off accompanied warnings of a EU disintegration, a UK break up and the possibility of a global recession. Once again, investors shrugged off the fears and US equities made fresh all-time highs this week.
US equity market volatility is almost certainly the result of two opposing forces. On one hand, extended valuations mean US equities remain vulnerable to geopolitical shocks and economic risks. On the other hand, asset prices, more particularly equities, remain supported by the Fed and central bank policy stimulus. While this juxtaposition exists, the only constant will be heightened volatility as investor sentiment swings between fear and optimism.
The end of the US earnings recession?
Meanwhile, FactSet reports that analysts expect the S&P 500 to show a 2Q 16 earnings decline of 5.2%. This will mark five consecutive quarters of earnings declines. The last time this happened was preceding the GFC. However, this trend is expected to end in the 2Q, with analysts forecasting a return to positive earnings growth in the 3Q (+1.1%) and the 4Q (+7.4%). As a result, forecast 2H 16 S&P 500 earnings growth is expected at +4.2%.
As the FactSet chart below shows, while the US economy has avoided a technical recession, corporates have endured an earnings recession for the last two years. As such, US equities have been supported by PE expansion rather than earnings growth. This trend has seen the 12 month forward S&P 500 PE expand to 16.9x or 18% above the 25-year average.
But if 2H 16 analysts’ expectations are realised and earnings recover, the “E” in PE could support sustainable price gains. This could represent an important turning point for the S&P 500 index which has been constrained by strong technical resistance around 2100 since peaking in May last year.
Earnings upgrade cycle?
US analysts forecast seven out of 10 S&P 500 sectors will show positive 2H16 earnings growth. Materials (+13.8%) is the clear leader, followed by Utilities (+12.1%), Financials(+11.7%), and Consumer Discretionary(+9.1%), Healthcare (+7.4%) and Consumer Staples (+5.7%). Energy (-31.8%) leads the three sectors expected to show earnings declines.
At the industry level, Metals and Mining (+291%) is expected to show the biggest turnaround for the Materials sector. At the company level, the return to profit of Freeport McMoran provides over 50% of the gains. Excluding Freeport, sector earnings growth falls from 13.8% to 6.1%. Similarly, at the company level, NRG provides a big contribution to the Utilities’ gains. Excluding NRG, sector earnings growth falls from 12.1% to 7.7%. In the Financial sector, Insurance (+41%) and Capital Markets (+28%) are the major drivers at the industry level, while AIG and Goldman Sachs provide the largest contributions to earnings growth at the company level.
The latest US GDP figures confirmed a pick-up in consumption spending. So at the industry level, consumer discretionary is showing broad-based growth. At the sub sector level, Housewares and Speciality (+127%) and Internet Retail (+50%) are expected to be the leaders in sector earnings growth, while at the company level Amazon (+180%) dominates 2H earnings growth. In the lead up to the 2Q 16 reporting season, Healthcare leads all sectors in terms of positive earnings guidance, so it’s no surprise that analysts are upgrading industry earnings.
Think global – act local
The 2H 16 is looming as a critical period for US and global equity markets. In a climate of low growth, and constrained by extended valuations and declining earnings, US equities have remained range bound for nearly 15 months. Set against this uncertainty is a supportive Fed and “easy money” central bank policy. The financial elastic is stretched tight. The indecisive trend will be broken by a violent move. That’s clear. But which way?
The early signs of a 2H 16 earnings recovery in the upcoming reporting season could provide the long-awaited “E” for US corporates, enabling earnings-driven, rather than price-driven equity gains. Such an eventuality could enable the S&P 500 to push through strong technical resistance around the 2100 level. At the same time however, risks remain elevated, with negative bond yields reflecting a “new normal” low growth, low inflation environment. More importantly, yield curves continue to flatten with many tending to inversion. There are many conflicting signals.
From a local perspective, the return to positive growth for the US Materials sector is instructive for Australian resource stocks. The main drivers of the Materials’ earnings recovery are lower impairment charges, cost-outs, and reduced capital expenditure. In short, it appears that Materials are past the bottom of the cycle and remain poised for a classic early stage recovery after a near five year bear market. It’s clear that BHP and RIO share a very similar outlook.
In addition, it was very interesting to note the performance of domestic resource stocks through the Brexit correction. In “risk off” events, cyclicals are usually relative underperformers. But BHP and RIO’s share price resilience was encouraging. Is the recent resource sector recovery the start of a new bull market or a short-term rebound driven by a weaker US dollar? The direction of the US material sector deserves close scrutiny.
All in all, the current US earnings season is vital to confirm the breakout of the S&P500 to new highs. The next two weeks will be very, very interesting because its one thing for markets to rally on the hopes of further central bank support, but long-term gains must be driven by earnings growth. US equities, after five consecutive quarters of negative earnings growth could be at the nadir and looking out the other side.
This all needs careful watching, but fingers crossed we do see a better than expected US earnings season and the S&P500 holds above technical support at 2100. The end of the US earnings recession would be good for all of us.
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