Equities continued to march higher into the new year, and ahead of the start of the fourth quarter earnings season, which kicks off this week. Despite that new records of global COVID-19 cases and more severe restrictions were announced over the past weeks, cyclical sectors have benefitted from the reflationary trade. Vaccine optimism and expectations for further accommodative monetary and fiscal policies, have fuelled growth expectations, supporting the favourable market outlook for equities into the new year.
From a fundamental point of view, the year 2020 was characterised both by an equity market rally, from March lows, and a series of earnings expectations downgrades. As a result, absolute valuations were pushed higher to historical extreme levels. US equities, represented by the S&P 500 index are currently trading at 22.8 times forward earnings, compared to a five year average of 18 times. Similarly, European equities, gauged by the Eurostoxx 600 index are currently trading at 17.9 times forward earnings compared to a historical average of 15 times. While this may be interpreted as expensive, equities remain attractive on the basis of earnings growth potential.
Therefore, the key measure driving returns going forward, is earnings growth momentum. From a bottom-up earnings perspective, the third quarter earnings season was a clear inflection point. After a series of earnings downgrades that reflected the pandemic pressures, the third quarter earnings season featured strong sales and earnings surprises, particularly in the US. Albeit that year-on-year sales and earnings declined, the US equity market, in aggregate, recorded a double-digit earnings surprise of 19 per cent. The earnings surprise was recorded across all sectors except for real estate, but was particularly evident across cyclical sectors such as energy, consumer discretionary and industrials. Similarly, in Europe, although suffering a more significant quarterly earnings decline, the third quarter results featured strong earnings surprises on the cyclical sectors, namely energy, consumer discretionary and financials.
Given the key developments on the vaccine discovery in the fourth quarter, together with the supportive macro environment, earnings expectations have since then continued to tick higher. According to Factset, the bottom-up earnings per share estimate for US equity index, S&P 500, has increased by 2.3 per cent during the fourth quarter. Albeit the small percentage, this highly contrasts with the usual reduction in earnings estimates in the final quarter of the year. In fact, forward earnings per share estimates for the US equity index have increased to $168, from the lows of $140.
This quarter earnings season, which will cover fourth quarter and full year results is expected to remind us the overall impact of the COVID-19 pandemic on various industries, particularly customer facing services such as travel and hospitality. However, it also creates an opportunity to assess the earnings potential going forward. Financial markets, forward looking in nature, are more likely to be interested on management’s forward guidance.
It is expected that the the slower vaccination progress and the renewed economic lockdowns are likely to keep expectations muted for the first quarter of the year. Nonetheless, ongoing support from monetary and government authorities should create a supportive macroeconomic environment going forward. A successful vaccine roll-out, together with pent up consumer demand should then act as the key driver to earnings growth going forward, particularly in the hardest hit sectors of this economic downturn.
Disclaimer: This article was written by Rachel Meilak, CFA, equity analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.
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