Watch for ebbing economic momentum as survey data peaks
Despite the increase in equity market volatility, there has been little follow-through to economic fundamentals to date. US earnings forecasts have stabilised and are indicating mid-teens profits growth for 2018, of which approximately one-half appears to be due to US tax reform. US economic surprise also remains relatively strong. In Europe, however, unweighted earnings estimates have continued to fall, if modestly, and perhaps more importantly here economic surprise indices have turned sharply lower. We view this as partly due to Brexit uncertainty in the UK and a rising EUR exchange rate in continental Europe.
Exhibit 1: 2018 Consensus earnings growth forecasts showing US “Trump bump”
In the US, earnings forecasts for 2018 have stabilised following the tax-reform induced step-change over the turn of the year. US corporate tax reform is also an interesting data point for future reference, as it shows how the full impact of a well-publicised event has taken as much as eight weeks to be incorporated into consensus expectations. As US markets have fallen modestly at the same time as earnings forecasts have risen, this has for value investors at least been a helpful de-rating of the US equity market.
Consensus forecasts for US equities call for earnings growth of 17% during 2018. It is critical in our view that earnings forecasts remain stable in order for there to be a realistic prospect of a “soft landing” for US equities. This is the scenario in which markets move sideways and valuations move closer to long-term averages as underlying profits grow (and interest rates are re-normalised). The relative weakness of the dollar has also been helpful in this regard, and we would note that while survey data has eased from recent highs and economic surprise indices have softened somewhat, the recent pick-up in equity market volatility appears to have had no impact on US corporate fundamentals to date.
Exhibit 2: Economic surprise indices falling fast in Europe and UK, but holding up in US
In Europe – and notably both in the UK and on the continent – there has been no one-off benefit from tax reform, and the unweighted average 2018 earnings forecast for companies in the region has continued to soften, albeit modestly. The economic surprise indices have also fallen sharply.
In the UK, the uncertainty over Brexit is now in our view making a tangible impact on the financial services and real estate sectors. Brexit should in theory have proportionally less effect on continental Europe, but we note economic surprise indices have fallen faster from a higher level. This is in our view likely to be in part due to a dampening effect on activity from the rising EUR exchange rate.
Exhibit 3: 90-day change in 2y yield spread between US and Germany – a widening differential
The strength of the Euro is also likely to be uppermost in the minds of ECB policymakers as unconventional monetary policy is withdrawn. Given the exchange rate movements and slowing European momentum, it is not a surprise that US short-term interest rates have been rising significantly faster than in Europe over the last three months. We believe it continues to be unusually important in a top of cycle environment to keep abreast of indicators which may reveal a turn in economic momentum.