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Since the global financial crisis, US equities have delivered strong returns. Crucially, those returns are supported by solid earnings growth. There’s a common perception that US equities are factoring in unrealistic earnings expectations, on hopes of a fiscal stimulus and other changes proposed by President Donald Trump.
But 2018 earnings estimates are actually lower than they were before the US election, while still 5 per cent higher than current 12-month forward earnings estimates.
Historically, the ISM manufacturing business survey has been a good lead indicator of US earnings and it is currently signaling continued earnings growth for US corporates. US equity bear markets have generally only tended to start once there is a noticeable deterioration in the labour market.
A rise in the number of initial jobless claims has often been a clue that trouble is ahead for the equity market. However, both this measure and the labour market in general currently remain healthy.
US valuations
US valuations aren’t cheap, but nor are they particularly expensive by historical standards. Looking outside of the US, valuations are slightly cheaper, but not dramatically so, and they are broadly in line with their long-term averages. Rather than relative valuations driving performance, the relative performance of future earnings is more likely to be key for stock market performance.
The earnings recovery in the US is well advanced, whereas the earnings recovery in Europe and the emerging markets are only really just getting under way after five years of contraction. So even though US earnings should continue to expand, the upside for markets where earnings are coming off of a lower base could well be greater than it is in the US.
Positive potential
Over in Europe, earnings have struggled in recent years. The underperformance of European earnings relative to those in the US has explained the consistent underperformance of European equities over most of the period since the global financial crisis.
As an improving European economy leads to higher nominal growth, driving higher sales, European margins are starting to improve due to operational leverage. Rising margins can amplify decent sales growth into even stronger earnings growth. And with margins very depressed in Europe, similar economic growth to that in the US should translate into stronger earnings growth.
After a strong start to the year, many investors are concerned that they have missed out on the rally in European equities and that it has become a consensus overweight. However, flow data suggests that political concerns led to very large outflows from European equities last year and that those flows have only recently started to return. Many investors who sold out last year are yet to return, suggesting that if earnings growth remains healthy and political risk remains subdued, more money could yet return to European equities.
To sum up, US equities should still deliver positive returns over the next year, helped by continued earnings growth, with even greater potential upside if there is fiscal stimulus from the US administration. However, there may be greater upside in equity markets outside the US where earnings and margins are coming off of a lower base, such as in the emerging markets and Europe. These considerations will point many investors in the direction of a broad overweight to equity markets with a particular bias towards European equities.
Nandini Ramakrishnan is a global market strategist at JP Morgan Asset Management
