We are now around halfway through the earnings season in the US and company results are beating analysts’ estimates by a wide margin: Not only that, but profit estimates for the next few quarters are also seeing significant revisions higher.
Following major lockdowns, a strong recovery of sorts might be expected but, so far, earnings have risen in the US by nearly 90% and revenues are up over 20%, this is way above expectations. In fact, earnings, on average, have beaten expectations by around 18%, well above the average of 4%. While it is still early days in the UK reporting season, results here, so far, have also been very strong. So why does this matter so much? There are a number of financial commentators and investors who are worried over high stock valuations, particularly in the US where the S&P 500 trades at over 20x PER for 2022 (much lower in the UK and Europe). This is very high by most historical measures but can be explained away in part by the current economic environment of very low and sustainable interest rates, subdued inflation and recovering economic growth. However, were this to change, and there is certainly a worry over rising inflation, then this would likely cause some volatility in bond and equity markets as sentiment adjusted. The strong earnings picture is, therefore, reassuring in that it helps to reduce the valuation level and alleviates the pressure on share prices.
While the rising earnings profile removes one risk to the markets, there are certainly other factors to consider. If we assume that inflation is transitory, as central bankers keep reassuring us it is, why do companies remain concerned over raw material prices and commodities, as well as labour costs, which have picked up strongly as economies have re-opened? These have largely been passed on to consumers for now as they enjoy their new found freedom, but there is a limit, over the medium term, as to how long this can be sustained. If these input prices remain stubbornly high, the profit margins are likely to be squeezed, which will be a drag on profitability. However, for now at least, most companies appear able to pass these on or absorb the costs.
The financial markets are now working on the assumption that the pandemic is being brought under control and global growth will continue to accelerate as recovery takes hold. In most developed economies, this seems to be the most likely outcome, but occasional lockdowns may yet slow this process. There is still the possibility that developing economies could struggle for a while longer, at least until their vaccination programmes are rolled out. We may see a continued economic lag here, but their markets are likely to play catch up over time and could well see renewed strength as rotation and the year progresses.
In conclusion, although equity market valuations area at the upper end of historical levels, the present reporting season is giving some comfort that these can be maintained, especially while the recovery continues. A prolonged period of stubbornly high inflation, whether in the US or Europe, seems to be the most likely cause of any future market volatility, but, while not immune, the European markets and much of the developing world should be better able to weather this with its much lower valuation levels.
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