Positive margin dynamics, but stretched equity valuations

Second-quarter results were well above estimates, but average earnings surprises were modest in the US and consensus estimates for 2018 have stalled.

The Q2 2017 reporting season demonstrated that corporate results dynamics remain robust across developed economies. Sales and profit figures came in well above estimates in the US, Europe and Japan. The trend for profit growth has sustained equity markets’ total returns in the year to date. But due to the weakness of the US currency, returns in that currency are stronger in Europe and Japan than in the US.

In Q2 2017, two thirds of US companies posted positive earnings surprises. Nearly 60% of S&P 500 companies surprised positively in terms of sales and 66% beat profit estimates. But the average surprise was fairly small at 1.2% in terms of net income and 1.3% in terms of sales. As a result, profit margins were broadly in line with expectations. In Europe, 60% of companies reported sales figures above estimates, including 88% of banks. At 4.7% and 8.9% respectively, average sales and profits surprises were more substantial than in the US, as European companies continued to improve their margins.

Japan led the pack in terms of net income surprises, with nearly 70% of Topix companies beating profit estimates in Q2, while 55.4% of them surprised positively in terms of sales. Margins improved as well and net income was 16% higher than expected. But Asia (ex Japan) lagged in terms of positive sales and net income surprises in the second quarter.

There was a decline in consensus 2018 estimates for earnings growth on both sides of the Atlantic over the summer (to just under 9% in Europe and 11.6% in the US), whereas they have remained stable in Japan (7.7%). The current 2018 consensus earnings estimate for the US does not seem to take into account the effect of any fiscal stimulus from the Trump Administration which, in our view, is becoming increasingly unlikely. Equity market valuations remain stretched across major economic regions by historical standards. Finally, investors should note that on a comparable basis (i.e. adjusted for sector bias), European equities are roughly as richly valued as their US counterparts.

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