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Earnings Season Not Adding Up

Key Points
  • Earnings are estimated to  decline from a year ago in the first half of the year for companies in both the U.S. and Japan, while European companies may see relatively stronger earnings growth.

  • Stock markets around the world have posted steady double-digit gains this year on a rebound of valuations, but without support from earnings growth, volatility may return.

  • Fortunately for investors, the degree to which the world’s markets move in sync with each other has fallen to the lowest level in 20 years, enhancing the potential risk-reducing benefits of global diversification.

Economic growth rates have been revised lower in recent months by economists and central bankers for countries around the world. Yet, the expected earnings per share growth rate for companies around the world next year has been rising for most of the past eight months, and now stands around 10%.

How does this add up?  Well, earnings estimates for both 2019 and 2020 have declined by about 6% as they reflect a weaker growth outlook. However, estimates for 2019 have been coming down faster than those for 2020, resulting in a higher implied growth rate of earnings , but on a lower dollar amount of earnings, as you can see in the chart below.

Earnings per share expectations for 2019 and 2020

MSCI EPS

Source: Charles Schwab, Factset data as of 4/22/2019.

Earnings recessions

The consensus of analyst earnings estimates for companies reflect single-digit growth for 2019 in each of the three major countries and regions. However, the first and second quarter are currently expected to suffer back-to-back declines from a year ago in both the U.S. and Japan, sometimes referred to as an “earnings recession.” Europe is expected to avoid an earnings recession with losses limited to the first quarter (following a slight 1.8% gain in the fourth quarter of 2018), contributing to stronger earnings growth in 2019 than in the U.S. or Japan, as you can see in the chart below. It is noteworthy that despite Europe’s relative economic weakness, earnings growth is anticipated to be the strongest of the three in 2019.

Expected earnings per share growth rates by geography

Expected EPS by country

Source: Charles Schwab, Factset data as of 4/22/2019.

Not adding up

Analysts expect the broad weakness in earnings to be limited to the first half of the year, with a rebound in the second half, resulting in solid gains for the year as a whole. Yet, economists do not foresee stronger economic growth in the second half of the year. It doesn’t seem both can be right, so what is it about the earnings outlook isn’t adding up? Without faster revenue growth driven by a pickup in economic activity, how can analysts expect companies to achieve double-digit earnings growth in the second half of 2019?  We see two possible answers: 

  • Analysts may be anticipating falling input costs—yet costs for two major inputs, labor and energy, which have been on the rise this year. It’s hard to see what could turn these prices sharply lower in the coming months without also weakening sales growth.
  • Economists may be wrong and second half revenue growth will be stronger on a reviving global economy fueled by fed rate cuts, trade deals, and corporate tax cuts. Yet, leading indicators for the world’s major economies, such as the composite leading indicator from the OECD (Organization for Economic Co-operation and Development), have been pointing to slower growth in the second half of the year.

There is something else that isn’t adding up: the difference in growth expectations between earnings and economic forecasts also seems to be showing up in the stock and bond markets. The bond market now seems more concerned about the economic growth outlook than the stock market. After moving in sync last year, global stocks have rebounded while the U.S. Treasury yield curve has not, as you can see in the chart below.

Stocks and bonds reflecting different growth outlooks in 2019

MSCI World Index vs 10-year 3-month Treasury spread

Source: Charles Schwab, Bloomberg data as of 4/26/2019.

Seek diversification

While stocks have posted steady double-digit gains this year on a rebound in valuations, without support from earnings growth, volatility may return. 

What should investors do when things don’t appear to be adding up? Be sure they are adequately diversified. Fortunately, diversification has made a comeback. The degree to which the world’s stock markets move in sync with each other has fallen to the lowest level in 20 years, as you can see in the recent commentary: Diversification: Finally Back After 20 Years. The lower correlation enhances the potential risk-reducing benefits of global diversification.

What you can do next

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
 
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International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.  Investing in emerging markets may accentuate these risks.

The MSCI World Index captures large and mid-cap representation across 23 Developed Markets countries. With 1,632 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The S&P 500® gauge of large-cap U.S. equities includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. 

The STOXX Europe 600 Index has a fixed number of 600 components and represents large, mid and small capitalization companies across 17 countries of the European region.

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