Earnings growth is not a prerequisite for higher equity prices

With global growth leveling off, investors are more focused than ever on corporate results. These reveal a less rosy picture than in previous years and company expectations are very muted. The good news, however, is that lower earnings growth isn’t necessarily a problem for the stock markets, provided the decline is temporary.


In many ways the current period is comparable to 2015-2016, when the global economy cooled and, as we’re seeing now, investors watched the Federal Reserve and China with bated breath. Earnings per share stalled, even falling into negative territory from the third quarter of 2015, and didn’t start to move higher again until the end of 2016. In the meantime, however, both the Fed and the Chinese government stepped on the gas and thus prevented a global recession.

In anticipation of this, the MCSI World Index bottomed out in February 2016 and subsequently rose until December – the point at which company earnings started to increase again – by a very respectable 21%. A time period like this between market bottom and earnings growth is not all that unusual. According to calculations by J.P.Morgan, the MSCI World Index bottomed out five to ten months before earnings growth became positive again in all four of the serious growth slowdowns and recessions over the past 20 years (1998, 2003, 2009 and thus 2016).

The stock markets rose sharply in the months after the market hit bottom and earnings growth started to climb again. Once equity investors begin to suspect that the end of the earnings dip is near, the markets pick up again.

Recovery on the horizon

The question, of course, is whether we can expect another period like that now. In other words, will the earnings dip be followed by a period of earnings growth anytime soon? There’s a reasonable chance we’ll see a slight fall in earnings per share in the coming quarters. The last point on the above graph shows an earnings growth rate of 16%, but this is highly skewed by the tax advantage that US companies enjoyed last year.

If we detract this ‘gift’, US earnings fall back to 4%, compared with a 7% decline in earnings for the rest of the world. More important, however, is whether earnings will recover again later this year. The chance of this is also considerable. The Federal Reserve has made some significant policy shifts in anticipation of less flourishing times (leading you to wonder whether it’s actually being a little too cautious).

And China is stimulating its economy, as it did in the 2015-2016 period. Add to this the still-strong corporate revenue growth and fact that US companies in particular are spending billions buying up their own stocks, and the conclusion is that that earnings per share should be able to increase again in the last quarters of this year.

What could go wrong?

As always, this scenario is not without risk. We are a few years further into the economic cycle now and thus also a few years closer to its end. And although the Federal Reserve has taken steps to normalize its monetary policy, this certainly doesn’t apply to all the other major central banks. There is limited opportunity for stimulation. The same applies to China, which cannot and does not want to use unbridled credit growth to boost economic growth.

But our base scenario is that we will not see a recession this year, but rather a cautious recovery aided by central banks and low interest rates, moderate Chinese monetary stimulation and strong labor markets. Generally speaking, this should also be accompanied by higher earnings per share.


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