Earnings have been on a downtrend since the global economic expansion lost momentum in the second half of 2018. To date, the trailing earnings per share (EPS) growth of the S&P 500 Index has shrunk to a meager 1.6% year on year, while on the MSCI AC World Index, it has actually fallen by 0.6%. Meanwhile, global equities have risen by a whopping 17.6% in the 12 months to the end of November.
“Clearly, we have been experiencing a ‘zero earnings growth’ bull run lately,” says Van der Welle, a strategist with Robeco’s Global Macro multi-asset team. “It begs the question whether the apparent blissful ignorance of the peak in earnings in the rearview mirror matters at all for an aging bull market going forward.”
“Currently, we are in the decelerating segment of the US corporate profitability cycle, as US corporate tax cuts benefits have faded, while unit labor costs have risen. Profit margins are still at decent levels, but the consistent downtrend bears striking similarities with the late-cycle behavior that has preceded previous US recessions.”
Van der Welle says it is important to look at the peaks and troughs in trailing earnings growth – the profits reported over a past period – and compare them with projections for forward earnings growth to get a better idea of what might happen next. US trailing EPS growth peaked in Q4 2018 against a backdrop of escalating trade tensions between the US and China, but may not yet have troughed.
“Financial markets are forward looking and typically anticipate the next phase in the business cycle,” he says. “Major market movements often precede major inflection points in the cycle. Therefore, with hindsight, one may observe that the market rout which erupted in early Q4 2018 was already instigated by the anticipated peak in S&P 500 earnings and the expectation of an overall subsequent earnings growth deceleration taking shape in 2019.”
“However, in waiting for reflationary forces such as more fiscal and monetary stimulus to appear further down the road, this market has defied the downtrend in earnings during 2019.” This is shown in the chart below, with the weighted trailing EPS of the S&P 500 clearly falling while the index itself keeps on rising.
“The question is how long a bull market can withstand such a downtrend in the earnings environment, and the answer is not indefinitely,” says Van der Welle. “Our analysis of the last ten major peak-to-trough moves in the S&P 500 12-month forward earnings figures shows that equity market returns were negative on average (-0.6%) 12 months after a peak in forward earnings.”
“However, not every earnings downtrend is created equal with respect to its equity market impact. There is a distinction to be made between a recessionary and a non-recessionary earnings downtrend.”
“For example, the recessions that occurred from October 2000, November 2007 and June 2008 all coincided with deepening market sell-offs. But the other peak-to-trough forward earnings trajectories (in 1995, 1998, 2002, 2014, 2015 and 2018) all saw equity markets move higher instead.” This is shown in the chart below.
So, what does this mean for markets? “Our base case is that we are likely to see reflation in 2020, and are therefore currently experiencing the non-recessionary earnings slowdown variant,” says Van der Welle.
“Our US yield curve-based recession indicator points to a 30% probability of a US recession in 2020, leaving us positive on equities. With a 70% implied probability of an extension of the cycle, the odds favor equity markets making new highs.”
“In summary, the current environment of declining corporate profitability may not necessarily usher in a bear market. But tactical caution is needed, even if we are seeing the cycle extended, and waiting for reflation keeps paying dividends.”
Van der Welle says the direction that earnings are about to take as markets head into 2020 is key, as late-cycle bull markets will hinge on earnings delivery.
“This is especially true for the current late-cycle market, since the space available for conventional monetary policy to prop up risky assets is rather limited from a historical perspective,” he says.
“Markets can only stay irrational, or without policy support, for so long. Analysts already expect S&P 500 earnings to trough in Q1 2020 and to improve as the year progresses. This could be on the optimistic side, as reflation and the bottoming out in earnings could take longer to unfold in 2020 than consensus expects – as it did back in 2016.”
“While we stick to our reflation base case for 2020, the early 2020 reflation hypothesis is being put to the test in our view. A couple of factors have somewhat reduced the odds of an early 2020 reflation. The further weakening of the November ISM manufacturing producer confidence index to 48.1 – a number released prior to US President Trump’s warnings about a potential postponement of the trade deal – shows that spillover risks to the services sector have not vanished either.”
Subsequently, the Robeco Global Macro multi-assets team has been taking some risk off the table. “We have reduced our equity exposure in recent weeks, as the upside for tactically taking equity risk has diminished in our view,” Van der Welle says. “This has left us with a marginally overweight position in global equities and an underweight in global high yield bonds.”
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.