In one chart:

Does an earnings recession signal an eventual equity correction?

Sébastien Galy, Sr. Macro Strategist Nordea Asset Management  


Falling earnings have often been cited as leading to an eventual equity market correction. At a first glance this looks good, but it’s more complicated analytically as investors would have to be irrational to not learn from the past. A compression in earnings comes from higher wages and capital costs relative to revenues. In the latter stage of the business cycle, an economy above the output gap tends to benefit labor while monetary policy is typically tighter. The question is then whether the Fed can engineer a soft landing or if there is an accident ahead such as the collapse of a bubble. Equities will see through this dip in earnings to look at the business cycle beyond. In the case of high growth sectors, the high discount rate of cash flows makes them very sensitive to the temporary earnings compression. Conversely, mature sectors are less sensitive to a temporary bout of earnings all things equal. Is the market rational in expecting a soft landing starting in 2020? The odds of this seem good.

We saw a compression in earnings and indeed an earnings recession in Q1 while equities were flying of the shelf courtesy of an extended Fed pause. The compression in earnings is mechanical:  earnings are often backward looking and guided by corporations, hence the information they provide is somewhat limited. This is called bottom-up analysis in contrast to top-down analysis done by asset allocators. A look at the conference calls and their respective earnings guidance helps to build a forward-looking picture of mature sectors versus growth sectors and the challenges they face. For example, Kit Kat has pricing power in the US, but not in Europe or Japan. From this cluster of qualitative data, one can cross-check and enhance the top down view. While there are signs of inflationary pressures in some mature less skilled sectors, there is little sign of heavy capex.

The current problem is less earnings and more geopolitics. The imposition of higher tariffs on China even as Vice Premier Liu heads to Washington D.C. to negotiate a deal leaves for very bad optics at home. The US would need to back down somewhat for China to save face; we are seeing the start of a face-saving strategy. First, there is no embarrassing leak from the US administration and second, President Trump is now being portrayed as having acted alone as his impulsive self. Having said that, China overplayed its hand recently and may still overplay it again by assuming the Trump administration is afraid of a market correction. In reality, the Trump administration is focused on getting its leader re-elected and that may well mean expanding the tariffs. The question is therefore whether the Chinese will blink first because they value short-term growth over longer-term objectives. The next few days may unfortunately be quite volatile.

 

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About Nordea Asset Management

Nordea Asset Management (NAM, AuM 217.2bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 300.2bn EUR*). NAM offers European and global investors’ exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Santiago de Chile, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 31.03.2019

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