Higher earnings, please

Good morning. The magnolia trees are blooming in New York City, baseball season has begun and young hearts everywhere are turning to love. That’s right: first-quarter earnings season is here. The big banks start reporting on Friday. The news will be good. But perhaps not as good as it should be (see below). Meanwhile, email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Why aren’t earnings estimates higher?

This is a robust economy. We’re on track to grow at a 2.5 per cent rate in the first quarter, according to the Atlanta Fed’s GDPNow service, above the long-run trend and an impressive addition to the strong growth record. Last week’s manufacturing survey numbers showed a return to expansion, and Friday’s jobs numbers only reinforced the point. A net 303,000 payrolls were added in March, spread widely across sectors. Hours worked rose, defying recent predictions that labour market weakness was lurking beneath the surface.

Against such an economic backdrop, you’d expect similarly robust earnings growth. But judging by bottom-up analyst estimates, that’s not happening. The analyst consensus has S&P 500 EPS rising just 3 per cent year on year in the first quarter. And, as Robin Wigglesworth noted in Alphaville last week, outside of the Mag 7 the story doesn’t look terribly strong. Taking out the top 10 S&P stocks, EPS is expected to shrink 4 per cent in the first quarter, calculates Goldman Sachs. Partly, that is down to an especially sharp 27 per cent expected contraction in energy earnings. But weakness exists elsewhere too. Materials EPS are expected to fall 24 per cent and cyclically sensitive industrials to rise only 1 per cent (during a supposed manufacturing upturn, no less).

One way to square the circle is to argue that earnings estimates are too bearish. This is plausible, simply because earnings estimates have been too bearish for a while. The chart below from Goldman nicely illustrates, with actual results in light blue and prior estimates in dark green:

Binky Chadha of Deutsche Bank has recently put out a more optimistic S&P earnings forecast, partly in recognition of the strong macro data. Take industrial cyclicals (industrials ex a few pandemic-rattled stocks), where first-quarter estimates have flat earnings growth pencilled in. Chadha expects something closer to long-run trend growth, implying a 4 per cent first-quarter rise in EPS. Overall, his team is forecasting 9-10 per cent earnings growth, amounting to a historically average earnings beat. With economic growth at 2.5 per cent, this all seems plausible.

The more pessimistic view is that the bottom-up estimates are right, because the top-down view is missing some unpleasant economic developments. In recent weeks, more companies have hinted at early signs of a consumer slowdown. Costco shares have fallen 9 per cent since the company missed sales expectations in early March. McDonald’s is down a similar amount; last month its executives warned of a low-income consumer pullback. Perhaps they are seeing something at the periphery that hasn’t fully shown up in the macro data. S&P 500 margins, which never fully reverted to pre-pandemic levels, could suffer if the consumer loses more steam.

This is a long-standing fear, though. In the past, it proved overdone because distress stayed contained to low-income consumers. A strong US economy in aggregate can coexist with deterioration at the bottom. But as earnings season gears up later this month, investors will be looking anxiously for signs that the pain is working its way up the income ladder. (Ethan Wu)

The bargain hunt moves to Europe

As a value guy, this chart makes me feel a little crazy:

We’ve rattled on at some length recently about how UK stocks have become weirdly cheap relative to US stocks. (Or is it that the US stocks are weirdly expensive?) The same applies to Europe more broadly, to an only slightly less extreme degree. As you can see, since 2015 or so European large cap stocks have gone from a small, stable discount to a huge, ever-widening one. Why should this be? The difference is all the weirder when we look at the whole of Europe, a bigger, deeper, more diverse market than the UK.

As with the UK, some part of the Europe valuation gap is down to sector weightings. The S&P 500 is much more heavily weighted to information technology and communications, due to the impact of the very large technology companies, and is correspondingly lighter on most everything else:

But the gap is not just down to big tech. If you take the Magnificent 7 out of the S&P 500, its multiple moves from 22 to 19. The S&P 350 is at 14. 

More to the point, perhaps, is the fact that the US receives a premium to Europe in every sector save one — even relatively slow-growing ones like financials, energy, utilities and materials. In fact, in faster-growing information technology and healthcare, the US and Europe trade near parity. In the European tech sector, you can attribute the high P/E to heavy weighting of expensive ASML and SAP, which together make up half the sub-index. Novo Nordisk has a similar effect on healthcare:

Here is the tricky bit, though. In almost every sector, big-cap US companies have significantly outgrown those in Europe over the past 10 years — the period over which the US premium grew. I have taken financials out because the long-term growth data for the sector is spotty due to mergers:

The massive gap in communications growth rates is attributable to the fact that in Europe that sub-index is made up almost entirely of mature mobile telecoms industries. In the US it includes Meta, Netflix and Alphabet. 

The gap in US-Europe valuations looks less impressive when you look at the gap in historical growth (of course, it is future growth that really matters to valuations, but the record tells you something). But it still looks large. It is interesting, for example, that in consumer staples and industrials, Europe trades at a notable discount, but has demonstrated very similar growth. Those might be the areas to seek bargains. 

One good read

More on McKinsey’s astonishingly bad study of leadership diversity and financial returns. Critiques have been piling up for years. So far as I know, McKinsey has not responded, which is strange.

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