Wanted: Earnings Growth

| About: SPDR S&P (SPY)
This article is now exclusive for PRO subscribers.

Key points

  • We believe further gains in global equities this year would require a meaningful improvement in earnings.
  • The Federal Reserve (Fed) stayed put last week but upgraded its economic view, keeping the door open for a 2016 rate rise.
  • U.S. labor and inflation data this week will be key for confirming our view that the Fed will likely raise rates just once this year.

Global stocks are up year-to-date, having shaken off worries about the strength of the global economy in the wake of the UK's Brexit vote. But we believe further gains require a meaningful improvement in corporate earnings, particularly in developed markets.

Equity markets are running on fumes. The chart above shows how multiple expansion - or rising price-to-earnings ratios - has been the main driver of returns in many markets this year. Earnings growth has been flat to negative.

The main ingredient required for further gains

The worst of the U.S. profits recession appears to be over. Second-quarter earnings growth for the S&P 500 likely will still show contraction from last year's levels. Yet we find reasons to be marginally more optimistic about the second half. Sales growth has been better than expected, and is on track to turn positive for the first time since the fourth quarter of 2014.

We also see the energy sector's drag on earnings fading by year-end. The problem? High U.S. valuations and strong flows into U.S. equities already appear to reflect part of the good news. A U.S. market overweight has become a consensus trade, our analysis shows, raising the risk of sudden reversals.

In Europe, analysts have slashed their expectations for 2016 earnings growth since the beginning of the year on a collapse in expectations for the banking sector. Earnings are set to contract in seven out of 10 European sectors in the second quarter. The bright spot: global multinationals with geographically diverse sales, in sectors such as health care, materials and technology. In Japan, many companies are budgeting for a weaker yen in the second half, surveys show. This increases the risk of downward earnings revisions if the yen stays strong and hurts the overseas earnings of Japanese companies.

The main takeaway for investors: Be selective. We prefer quality companies that can increase earnings in a low-growth environment or grow their dividends. U.S. stocks with high dividend payouts, by contrast, look expensive and offer limited earnings potential at this time, we believe.

  • The Fed stayed put but upgraded its near-term economic assessment, keeping the door open for a rate increase later this year.
  • The Bank of Japan (BOJ) kept its policy rate and bond purchase program unchanged, but ramped up planned equity purchases. Japan also unveiled a large fiscal package.
  • Oil prices slumped to three-month lows under the weight of unexpectedly high U.S. inventories.

Global snapshot

Weekly and 12-month performance of selected assets

Equities Week YTD 12 Months Div. Yield
U.S. Large Caps -0.1% 6.3% 3.1% 2.1%
U.S. Small Caps 0.6% 8.3% 0.7% 1.4%
Non-U.S. World 1.8% 3.9% 4.8% 3.2%
Non-U.S. Developed 2.4% 0.4% -6.6% 3.4%
Japan 3.2% 0.5% -1.9% 2.4%
Emerging 0.5% 11.8% -0.6% 2.6%
Asia Ex Japan 0.3% 7.1% -1.4% 2.6%

Bonds Week YTD 12 Months Yield
U.S. Treasuries 0.7% 5.8% 6.1% 1.5%
U.S. TIPS 0.9% 7.2% 5.4% 1.5%
U.S. Investment Grade 0.5% 9.3% 9.2% 2.8%
U.S. High Yield -0.3% 12.0% 5.3% 6.7%
U.S. Municipals 0.3% 4.4% 7.1% 1.6%
Non-U.S. Developed 2.7% 12.9% 12.6% 0.5%
Emerging Market $ Bonds -0.2% 12.3% 11.7% 5.2%

Commodities Week YTD 12 Months Level
Brent Crude Oil -7.1% 13.9% -20.5% $42.46
Gold 2.2% 27.3% 23.2% $1,351
Copper 0.1% 4.7% -7.6% $4,925

Currencies Week YTD 12 Months Level
Euro/USD 1.8% 2.9% 1.7% 1.12
USD/Yen -3.8% -15.1% -17.7% 102.06
Pound/USD 0.9% -10.2% -15.2% 1.32

Source: Bloomberg. As of July 29, 2016. Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Barclays U.S. Corporate Index; U.S. high yield by the Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Barclays Municipal Bond Index; non-U.S. developed bonds by the Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

This post originally appeared on the BlackRock Blog.