Chart of the week – Of margins and valuations

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  • The Q4 market selloff reflected, among other things, falling earnings expectations, much of it in energy and Apple-related sectors; elsewhere, estimates rose, though more slowly
  • Can US earnings growth sustain above-average valuation ratios? Recent poor earnings guidance leaves less room for disappointment
  • European companies are containing costs, but poor revenue growth is preventing earnings from rising
  • Japanese earnings forecasts are suffering from lower global trade, but if a Sino-US deal helps to spur a broader trade rebound, Japanese companies could benefit disproportionately.

Markets skidded in the last quarter of 2018, under pressure from overly eager policy tightening by the US Federal Reserve and president Trump’s tariffs, but also crucially, from sharp cuts in earnings expectations, particularly in the energy, technology hardware, and semiconductor sectors. However, next-twelve-month earnings expectations for the remaining sectors continued to rise, though more modestly than in the first nine months of the year.

Worth the market price?

Now, lower US GDP growth, rising wages, and tariffs are making it harder for companies to lift profits at a fast enough pace to justify above-average stock multiples. Margins are under pressure. The cost of goods sold as well as selling, general and administrative costs are rising. Higher depreciation and amortisation charges, in addition to rising interest expense, have added to the burden. Expected earnings growth would have been worse were it not for a drop in taxes.

Chart of the week – of margins and valuations market

At a sector level, tariffs are hurting profitability, for example, for heavy users of steel and aluminium. There is less evidence, however, of wage pressures feeding through in those sectors where labour costs represent a higher share of costs. For instance, construction or computer electronics do not show an estimates of cost of goods sold rising more quickly than for other industries. While you might expect to see it in retailing, wages as a share of general costs are actually below the economy-wide average, so it may not be as big a burden as many people assume.

Is the worst behind us now that there seems little chance of further interest rate rises by the Fed and there are hopes of a possible trade deal with China that could lead to lower tariffs? The main reason for caution is the ongoing drumbeat of weak corporate guidance: the percentage of companies raising their guidance remains well below the levels of a year ago. There is a risk that another quarter of poor earnings surprises could be more severely punished by the market.

For Europe and Japan, it’s weak turnover growth rather than costs

While expectations for US companies earnings have been reset lower, the reappraisal for Europe and, in particular, Japan, has been much more significant. Forward estimates for the US are now just 1% below their fourth-quarter 2018 peak, but Europe is still 2.5% below and Japan nearly 7%.

Chart of the week – of margins and valuations market

The problem in Europe is weak sales growth: estimates are up by only 0.9% over the last six months. Costs have risen by only slightly more, notably in the healthcare and utilities sector. As in the US, lower expected tax payments offset some of the declines in pre-tax income.

Though the Japanese equity market looks inexpensive, with the market’s price/earnings ratio well below long-run averages, falling earnings estimates suggest why the discount may be there. Japan shares the problem of the US, with higher (market) interest rates reducing margins. In addition, lower global trade volumes are taking their toll. Export-oriented sectors such as cars and capital goods have seen the biggest falls in profit expectations.

The boost to sentiment, though, if and when a US-China trade deal is signed, could be all the greater.

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Daniel Morris

Senior investment strategist, CFA charterholder

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