Strategy Espresso : 3Q Earnings Preview: Expect a slightly negative to in-line season as slowdown in global growth offsets weaker euro
October 14, 2014
* Between now and the beginning of December, 301 companies representing 60% of the STOXX Europe 600 market cap will report their 3Q results…
* … with the last two weeks of October and first week of November being the most concentrated for results
* we expect a slightly negative to in-line season…
* …given the deceleration in global growth which will provide an offset to the support from the weaker euro
* … and the slowdown in negative earnings revisions, which removes the benefit of a lower hurdle to beat.
Reporting will be concentrated in the last two weeks of October and the first week of November, when 45% of the market cap will report earnings.
Last season (2Q) a high proportion of companies' results (38%) were in line with expectations on earnings, which gave a more neutral tilt to the equal-weighted average earnings surprise of +1.1%.
Using our analysis of five factors that impact earnings surprises, we expect the results this season to be slightly negative to in-line.
We analyze below in detail the evolution of these five factors: earnings revisions; the EUR exchange rate; the macroeconomic environment as represented by the GLI momentum; Euro area Manufacturing PMI and EM Manufacturing PMI.
Despite the tailwinds from a weaker euro, we are cautious on the 3Q earnings season given the deceleration in the macroeconomic environment. Moreover, the stabilization of downward earnings revisions means we do not have the benefits of a lowered hurdle to beat to the same extent as in recent seasons.
* Global Economic Activity: Global economic activity has been on a downward trajectory over the past quarter, driven by decelerating growth momentum in the Euro area and China as indicated by recent data. Euro area Manufacturing PMI has declined 2.9% from the average of last quarter, and our economists have downgraded their 3Q growth forecast to 0.1% (from 0.4%). This is a significant headwind for earnings given that almost half of revenue of the STOXX Europe 600 aggregate comes from the Euro area; as a result, we lowered our earnings growth estimates this year (see Strategy Espresso: Lower growth, inflation and Euro: What this means for our view on European equities, October 7, 2014). In fact, the latest estimate from RETINA, our economists' contemporaneous GDP and inflation tracker, points to a slight contraction in 3Q GDP of 0.15% qoq following weak outturns for Euro area exports and consumer confidence.
While aggregate EM economic activity, measured by the EM Manufacturing PMI, has shown a slight improvement, the latest China data have been weak. Accordingly, our China economists have downgraded their GDP growth forecast for 3Q to 7.8% qoq annualized (from 8.4% previously). The average GLI (global leading indicator) has declined over the quarter, and the evolution of our sales-weighted GDP echoes this picture of a softening global growth environment. This is a negative for the earnings season, since on our estimates the sensitivity of earnings to sales-weighted GDP is about 10x.
* Earnings revisions: Earnings revisions have begun to moderate over the past quarter, consensus 3Q earnings estimates have only declined 1.2% since July 1. This shows stabilization from downward revisions of 2.8% for 2Q earnings estimates and 8.7% for 1Q earnings estimates. Given that revisions have not been large the hurdle to beat will be less easy than in previous seasons.
* Weakening euro: The euro has continued its path lower, most notably against the USD, driven by the divergence in monetary policy and economic growth. Over the past quarter, it has declined 3.7% against the US$, 1.7% on a trade-weighted basis and 1.6% against an average of EM currencies. Since a depreciating euro boosts earnings, all else being equal, through a combination of translation effect, improved international competitiveness, and a boost to the domestic GDP (see Strategy Matters: Euro weakness: Sense and sensitivity, September 26, 2014) this should be supportive of earnings surprises. The strength of sterling, which was a headwind in the 2Q, has also subsided on a trade-weighted basis due to the dollar strength - GBP has declined 0.8% against USD although it is still up 1.8% on a trade-weighted basis. However, we do not expect the currency effect will be enough to offset the negative impact of the unfavourable growth environment since on our estimates earnings are more sensitive to GDP growth than to FX. While according to our estimates one percent depreciation of EUR vs the USD increases sales growth by 37 bp, there is a small offset at the margin level, reducing the impact on earnings to 20 bp. Currency effects should therefore impact sales surprises more than earnings surprises.
Things to focus on this season:
* Trailing earnings growth: The nascent growth in trailing earnings has been encouraging - over the year, 12-month trailing earnings have grown 3%. Given the macro weakness however we have lowered our full-year earnings estimates for 2014 to 5% and for 2015 to 8%. Our end-2017 EPS forecast is now below the 2007 peak. Because of the fragility of the earnings outlook any signs of an inflection point in earnings growth become more significant and therefore should be closely monitored.
Potential losers
* Cyclicals vs Defensives: Cyclicals have underperformed defensives significantly with the slowdown in global growth momentum. Cyclicals as an aggregate have seen only slightly more negative earnings revisions (-1.5%) than the market, although certain Cyclical sectors such as Industrials and Personal & Household Goods have seen significantly more negative revisions (-10.3% and -12.8% respectively).
* Germany: German economic data have been persistently disappointing, and the downgrades to our economists' growth forecasts have been more pronounced for Germany than for the rest of Europe (German 3Q GDP was revised down to 0.2% qoq from 0.6% qoq).
* Commodity-related sectors: Commodity prices have sold off sharply, reflecting global demand concerns as well as supply-side pressures. Brent crude declined 16% during the quarter, which should negatively impact earnings for the Oil & Gas sector, although Oil & Gas has seen downgrades of 2.4% in consensus EPS in the lead-up to this season.
Potential winners
* Financials: Financials contribute almost half (49%) of total 2014 expected earnings in our forecasts. While financials will help to lift the aggregate market earnings growth, this also highlights some vulnerability in our earnings growth forecast since financials saw large negative revisions over the past three years.
* International exposure: Companies with high international exposure should have benefitted especially from the weakening euro. Our new euro international exposure basket (GSSTEURO) comprises companies domiciled in the Euro area with a median international sales exposure of 76%. It will be interesting to see whether these companies have reaped the currency benefits.
* EM exposure: Earnings surprises for EM-exposed stocks seemed to have turned around in 2Q, after three seasons of significant underperformance. The continued moderation of EM headwinds this past quarter, including stabilizing EM FX and improving EM PMI, should again be supportive this quarter. On the one hand, the weakness in China growth may create headwinds, and the relative price performance of our EM Industrials basket (GSSTBRCI) in particular has continued to suffer.
Distribution of reporting
The exhibit below details the distribution of reporting market cap by sector. This season will be very concentrated, with the majority of reporting occurring in the last two weeks of October and the first week of November. The three weeks beginning October 20, October 27, and November 3 will be the most concentrated for results, totaling 45% of the STOXX Europe 600 market cap.
Sectors reporting are clustered around certain weeks: Technology (59%), Chemicals (25%) and Automobiles & Parts (20%) will kick off the season in the week starting October 20. The week starting October 27 will be particularly important, with many sectors seeing close to or over 30% of market cap reporting, including Health Care (41%), Chemicals (38%), Banks (36%), Automobiles & Parts (28%) and Food & Beverages (22%). It will be the biggest week for Oil & Gas, which will see 85% of market cap report. The week beginning November 3 will be the most important week for Insurance (48%), Construction & Materials (27%) and Telecommunications (25%). The week beginning November 10 will be the most important for Utilities (32%).
