Our views across equity markets have not changed given a quiet start to the year for both developed and emerging markets stocks. Given stretched valuations in markets like the United States it may take considerably better earnings and macro data to push stocks higher, while in comparison European earnings have been more lackluster (and growth slower) yet this was somewhat baked into valuations.
US first quarter earnings reports began on a weak note but have recently gathered momentum. Around 75% of US companies reporting through May 7 had beaten earnings estimates, with expected growth rising to 5% (year-over-year). The utilities sector has fared well, thanks to a cold winter that boosted demand for heating and electricity, as has the telecom sector, thanks to Verizon and AT&T. Results from financials were more lackluster, as investment banking suffered from diminished trading volumes and mortgage activity slowed. A variety of consumer staples firms used weather as an excuse for missing expectations; some consumer discretionary firms blamed a stronger currency. The first quarter GDP growth figure (showing just a 0.1% increase) confirmed subdued domestic economic activity, in part a payback for previous inventory builds, and in part attributed to colder weather.
European earnings are off to another slow start, despite a more flattering benchmark for comparison (earnings fell 5% in 2013). With around 70% of Bloomberg 500 companies having reported, just over half had met/exceeded expectations but growth (year-over-year) was essentially flat. Consumer discretionary stocks have been one bright spot, led by strong performance from automakers like BMW and Daimler. Consumer staples firms have disappointed, pointing to weaker demand in emerging markets and currency volatility as excuses. Companies have generally not blamed weak domestic demand, and releases thus far have contrasted with generally improving economic data. Eurozone PMI data, which normally tracks EPS growth, is the strongest in three years, though the labor market recovery has been less impressive given unemployment remains around 12%. UK economic data have been more impressive (3.2% annualized GDP growth in first quarter), with domestic demand more buoyant given a stronger labor market. Given first quarter results, consensus estimates for 2014 European earnings growth have come down from 13% six months ago to 8% today. Despite this, European equities have slightly outperformed developed peers year-to-date, supported by more favorable relative valuations and strong technicals. European stocks trade at roughly 14.5 times forward and 15.0 times normalized earnings, versus 16.5 and 21.5, respectively, for US equivalents.
Emerging markets first quarter earnings showed few clear patterns across sectors or regions. In Asia, 54% of Chinese companies missed expectations but aggregate growth came in at 8%; Korean earnings were disappointing across the board. This contrasted with macro data, where China is experiencing a policy-induced slowdown yet Korean growth is accelerating. In a similar vein Latin American results were mixed; for example, the majority of Brazilian firms beat expectations and growth was expected to be near 8%, yet the majority of Mexican companies have missed and earnings posted a considerable decline. Estimates for emerging markets earnings growth have come down only slightly since the start of 2014 and remain around 11%. This may appear overly optimistic given slower growth and monetary tightening in markets like Brazil, Russia, South Africa, and Turkey. However, bulls will note earnings growth has been healthy in heavily weighted countries like Taiwan, and point out earnings disappointment is more than factored in to low short-term valuations for countries like Russian and China, which trade at just 4.6 and 8.2 times forward earnings, respectively.
Our thoughts on markets have not changed in response to these first quarter earnings trends as relative valuations have not shifted. Our preferred equity portfolio tilts remain toward European and emerging markets equities versus US equivalents, given significantly lower valuations and factoring in earnings trends. We remain neutral on Japan—despite decent first quarter earnings macro uncertainty is high and valuations are not yet a clear “buy.” This said, we are closely monitoring some of the threats to earnings in emerging markets (Chinese rebalancing, Russian recession, etc.), and would become less constructive on Europe if stock price appreciation continued to outpace earnings for an extended period (or to a much greater degree).
Wade O’Brien is a Senior Investment Director on the Cambridge Associates Global Investment Research team.