As global earnings estimates continue to deteriorate in 2019, are falls in share prices leading to an economic recession or is this a more benign earnings downturn?
Andrew Grimes, Client Portfolio Manager, Alphinity Investment Management
Earnings estimates have deteriorated rapidly over 2018 and now into 2019. A switch from Quantitative Easing (QE) to Quantitative Tightening (QT), the global economic slowdown, margin pressures and a trade war made last year a challenging period for equity markets. Most impacted by deteriorating earnings have been cyclical sectors and regions such as Asia and Europe. The December quarter led to reduced earnings expectations in the US and growth markets such as Technology. Downgrades of US earnings forecasts are now as broad as the rest of the world, having previously been more resilient. At a sector level, relative earnings leadership remains tilted to defensives (Utilities, Health Care, Property), with cyclicals seeing the biggest downgrades (Consumer Discretionary, Diversified Financials, Materials).
With this backdrop of expensive growth companies and deteriorating earnings, the question we’re now faced with is: are we heading into an economic recession with further expected falls in share prices, or is this a more benign earnings recession?
An economic recession in 2019 is possible but far from certain. Financial conditions and leading indicators suggest growth is likely to slow further, potentially significantly; although a more dovish Fed and further Chinese stimulus are positive developments and may yet be enough to avoid a US recession this year. However, there are enough concerns including Brexit, US-China relationships and potentially another US government shutdown for investment managers to maintain a defensive tilt in their portfolios. For example, Consumer Staples such as global drinks company Diageo, the high-quality earnings of Microsoft, and Health Care companies including Roche and Merck have performed well and should continue to provide protection if conditions deteriorate further.
Currently, the more likely scenario is a global earnings recession that we are already 6-9 months into, leading to earnings expectations resetting in the next few quarters. This would create a more supportive backdrop for markets. But right now, earnings expectations still appear too optimistic. The recent shift in tone from the Fed is important, but investors may need more tangible evidence of this before stepping back in.
Once there is evidence that earnings have bottomed, this should lead to a more supportive backdrop for stock-picking thereafter. There are a number of attractive stocks with underestimated and undervalued earnings potential. Caterpillar is a ‘quality’ cyclical company that is fully exposed to global growth and should perform strongly when global earnings start to recover. Whilst the majority of European banks have been unattractive investment options, Lloyds - on a PE of 7 - now looks incredibly cheap. Lloyds is the highest quality UK bank and has a dominant position in the UK. Better clarity on Brexit should lead to an attractive buying opportunity.
Whatever scenario eventually plays out, Alphinity Global will continue to invest in those stocks that are showing earnings leadership, as we believe this approach provides the best opportunity for consistent outperformance.