There has been no argument repeated more by market bulls over the past several years than how irrelevant Europe is to S&P 500 earnings. Despite a significant recent deterioration in leading economic data in Europe, many bulls continue to consistently argue that solid earnings growth in North America and Asia can offset a weak but stabile EU economy.
To be sure, the S&P 500 and its tracking exchange traded fund, (SPY), has significantly outperformed the major European indexes by over 20% since the summer of last year.
Still, over the last five years, U.S. and European equity markets have generally been very closely correlated, with the S&P 500 and the FTSE closely correlated for most of the last several years.
Leading economic indicators have deteriorated significantly in the last couple quarters. While some poor economic data was temporarily overlooked in June and July, the recent export data coming out China and Japan was abysmal. Japan reported a nearly 25% drop in exports to the EU just in last six months. Growth in the EU has been weak for some time. Still, the significant recent slowdown in the world's biggest economic region appears to be weighing increasingly more on Asia and North America.
This is why I think the bull thesis that economic growth in the U.S. and Asia can offset weakness in Europe and most emerging markets is not a credible argument longer-term.
Corporate earnings grew at around 6% year-over-year in the first quarter, but second quarter earnings growth was much slower, and many leading multinationals were also increasingly negatively affected by forex moves as well. Companies such as Procter & Gamble (PG) and McDonald's were significantly affected by forex moves in the last quarter, with both companies seeing over a 3% drop in earnings because of the recent weakness in the Euro against the dollar.
While many leading industrial and energy companies are not heavily exposed to the EU, S&P 500 earnings are still significantly exposed to China, and Europe remains China's biggest trade partner. U.S. multinationals are still very reliant on China, and Chinese commodity demand has also been the primary driver of growth in major emerging markets such as Brazil, Russia, and Indonesia.
U.S. companies did report strong earnings in the first quarter of 2012, with market leaders in cyclical sectors such as GE (GE), Caterpillar (CAT), and engine maker Cummins (CMI), reporting strong earnings growth in North America. Still, Caterpillar and Cummins lowered guidance recently, and both companies' growth rates have continued to slow significantly over the last six months. GE issued fairly cautious recent guidance as well. Big cap technology companies with significant exposure to the EU, such as Intel (INTC) and Apple (AAPL), have seen earnings growth in Europe slow significantly in the last quarter as well.
With Japan and China recently reporting very weak export data, and even companies such as McDonald's (MCD) and Phillip Morris International (PM) lowering guidance recently because of weakness in the EU, it is clear that a slowing European economy is beginning to weigh more heavily on the U.S. and Asia as well.
While companies such as Apple and McDonald's did report fairly strong earnings in China, most industrial companies continue to report slowing revenue growth in the world's second biggest economy. Companies such as Caterpillar and Cliff Natural Resources (CLF) recently discussed weak Chinese demand for mining equipment and bulk metals, and casino companies such as Las Vegas Sands (LVS) and Wynn (WYNN) have also seen a significant slowdown in Macau since the first quarter. Visitation and spending numbers in Macau grew at the slowest pace in July since 2009.
While many leading U.S. industrials reported strong earnings growth in North America and cited a significantly improving outlook in nonresidential construction in the first quarter, these companies have been much more cautious looking forward. Leading economic data in the U.S. and Asia have also deteriorated significantly since the first quarter. The Empire manufacturing index recently went negative, unemployment continues to rise, and retail spending in the U.S. remains weak. China's PMI also recently came in at its poorest reading in nine months, and Japan's export data has continually been abysmal for several months.
To conclude, U.S. markets have significantly outperformed most European and emerging market indexes by a fairly wide margin over the last year. Still, many leading U.S. multinationals continue to report slowing revenue growth, and over 50% of S&P 500 earnings are outside of the U.S. Many leading industrial companies have also significantly lowered guidance in the past several months as well. While most U.S. companies reported fairly strong earnings growth in North America during the first quarter of this year, the growth outlook in Europe and most major emerging markets will likely have to substantively improve for most leading industrials to continue to report even modest earnings growth over the next several quarters.