Earnings season continues apace in the US and has begun within Europe. Of the 302 companies that have reported in the S&P500 index so far, 71% of companies have reported a positive earnings surprise. This compares to the 200 companies that have reported thus far in the DJ StoxxEuropean 600, where a mere 35% of companies have thus far posted third quarter earnings per share (EPS) above analysts’ expectations.
Between the US and European markets, two key bifurcations are taking place: market reaction to earnings surprises and analyst revisions to forward earnings forecasts for the end of the year, into 2012. The first distinction is the performance of companies that have reported well ahead of consensus (15% ormore EPS beat).
Good new not great news
In the US, companies who have posted such an earnings surprise have enjoyed the lowest level of relative outperformance since Q4 2007.
We note also that European markets have produced earnings less than had been predicted a year earlier, for much of 2011, in contrast to the US.
The second key difference between each side of the Atlantic has been the changing outlooks for earnings expectations into year-end and through to 2012. While the consensus estimate for 2012 EPS growth stands at 11% for the DJ StoxxEuropean 600 Index, many believe that the true figure will be lower.
Bank of America Merrill Lynch European Equity Research forecasts earnings growth no higher than 5% next year. Conversely, 2012 US earnings growth of over 10% (current consensus forecast), while optimistic, is still more probable than in Europe. Banks have been the principle contributor to upward revisions in the US but have surprised on the downside in Europe.
One last point giving rise to investor caution is the outlook for European dividends. Consensus 2012 figures of 10% growth individends per share are at odds with the 15% fall priced in the futures market. The experience of the Lehman Brothers crisis, which saw companies forced to cut dividends, undermined the sacrosanct nature of minimising dividend cuts in a downturn. Present investor sentiment and a growing temptation for indebted governments to tax more heavily cash on balance sheets may, in the medium term, put dividends under pressure.
However, corporate balance sheets are far stronger now than they were in 2008, deleveraging by companies having somewhat mitigated the risks of dividend cuts. As such, the need for investors to look for stocks that exhibit high, sustainable dividend payments, with chance of dividend growth, in quality companies becomes ever more important.
Overall strategy should not be changed in the wake of the European announcements. While one of the tail-risks (a disorderly Greek default and contagion through Europe) has been mitigated, until greater detail is provided (possiblyat the G20 meeting towards the end of this week), optimism should be cautious rather than unbridled.
Not out of the woods yet
That is to say, the announcements are not enough to sway us to eliminate our underweight European equity call. Apart from the earnings headwind on a relative basis to the US, there are still the difficulties faced by the European banking sector. Despite the relief rally last week (which was likely also driven by short covering), the sector still faces a period of serious consolidation in the midst of one the toughest operating environments in recent memory.
Giving more confidence to equity markets through to year-end will likely be the improvement in the US economy, which has clearly taken one step back from recession. The labour and activity data released this week should give a clearer steer as to whether strong momentum from the third quarter (Q3 US GDP was 2.5% annualised) is to be sustained through year-end.