Global Weekly: Improvement in earnings growth in 2020?

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The Euro Stoxx 600 Index and S&P 500 Index did not move substantially compared to last week. One reason is that the market is waiting for the third-quarter earnings season. Next Tuesday, some large health care companies and banks will kick it off. Most companies will present their results in the following four weeks.

As the management boards prepare their business results now, some will have to warn investors if business results have taken a different turn than previously stated. But the number of profit warnings have not been unusually high. So, it looks like most companies have already successfully communicated to shareholders the effects of the ongoing US/China trade war and the weakness in parts of the world economy.

The consensus estimate for earnings-per-share (EPS) growth in the third quarter for the S&P 500 Index is now -3%, with expected revenue growth of around 3-4%. For the Euro Stoxx 600 Index, the expected EPS growth is also -3%, but is based on 0% revenue growth.

In Europe as well as the US, the energy and materials sectors are pulling down these numbers. The cause is the steep drop in commodity prices at the end of 2018. The oil price dropped by 30%, resulting in lower revenues and around 30% lower earnings. Excluding these sectors, the expected earnings growth would be flat instead of -3%. As commodity prices have more or less moved sideways since the beginning of the year, this effect should fade away in the first quarter of 2020.

Another reason for the suppressed EPS growth (especially in the US) is margin decline at the large technology companies. Amazon is considered likely to book a 40% margin decline due to temporarily large investments that have been incurred to set up one-day delivery services in the US and for international expansion. Alphabet and Facebook will see a 15-20% margin decline, as they have temporarily increased investments in data protection and privacy. Other big detractors from EPS growth are Apple and the semiconductor company Micron. We expect the current high investment levels to normalise in the coming quarters, which could result in improving earnings growth in 2020.

The US consumer is holding up, but we do not expect a quick solution to the trade war and we continue to be worried by the deteriorating macroeconomic indicators; it therefore remains to be seen how much the earnings picture will improve in 2020.

Can central banks keep markets under control?

After a disappointing first week of October in terms of economic data, such as the Purchasing Managers Index, the second week of the month was more focused on the US Federal Reserve and the trade war. On 8 October, Fed Chief Jerome Powell, talking at a conference for business economists, did not shed any particular light on a new boost to the economy to come at the Fed’s next meeting later in October. Powell did, however, announce an increase in the purchases of Treasury bills to avoid a repeat of the recent liquidity tensions seen in overnight repurchase agreements (or ‘repo’) rates, which surged as high as 10% from about 2.25% (Repurchase agreements are a form of short-term borrowing for dealers in government securities.) Powell also made it clear that the US central bank is not now embarking on a substantial easing programme.

The yields on Treasury bonds and Treasury bills were, as expected, barely influenced by Powell’s remarks. Ten-year Treasury yields are at around 158 basis points (bp), which is just 12 bp above an all-time low. The minutes of the September Fed policymaker meeting gave the impression that the risks related to declining economic growth are viewed as paramount by most Fed policymakers. Further weakness in activity data is therefore likely to trigger more rate cuts this year, unless inflation data is much better than expected. The Fed has a target inflation rate of 2%.

We expect the Federal Reserve to lower its key rate by 25 bp in October and by an additional 25 bp in December. This is to encourage companies to keep on investing in support of the economy. In Europe, sovereign rates have been stable since the beginning of October, with no clear direction. Bund yields are stagnating at around -55 bp, which is far from the all-time low of -71 bp, which occurred at the end of August. Surprisingly, the Bund did not play its role as a safe haven when weak economic data was published earlier in October.

Disappointing manufacturing data and concerns about a slowdown materialised as a widening in credit spreads. This is especially true in riskier bond segments. US high-yield spreads widened by 37 bp and European high-yield bonds by 33 bps -- their highest level since mid-August. Emerging-markets bonds were more resilient, as spreads remained stable.

Trade talks between the US and China are set to resume, but the outcome remains impossible to predict. Given an uncertain political context (trade war, possible hard Brexit, etc.) and with the global economy slowing down, we continue to believe that the intervention of central banks can support the economy and prolong the economic cycle. This is based on central banks keeping interest rates low and, in Europe, restarting asset purchases (quantitative easing) in November. We therefore continue to favour an overweight duration position, with longer maturity bonds potentially outperforming bonds with short maturities. We also prefer European credits, which will likely benefit from the ECB’s asset-purchasing programme. We also retain a positive bias for emerging-markets debt over high-yield bonds. Accommodative (‘dovish’) decisions by the Fed favours a position in emerging-markets bonds, which could get even further support if the US dollar was to weaken. We believe that high-yield bonds are expensive, with limited upside potential (in euros or hedged to the US dollar) in the medium-term.

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