Stock markets globally continued to make progress in May, with the MSCI World Index (in C$) rising 0.9%. Concerns over the residential real estate outlook and the direction of oil prices weighed on the S&P/TSX index, resulting in a 1.3% retreat. The US 10-year bond yield ended the period at 2.2%, down almost 8 bps.
Beyond the impact of short term news, the intrinsic value of any investment is ultimately a function of two things: first, the future cash flow it generates, and second, the interest rate used to restate future cash flows (or corporate earnings) in terms of today’s money. Sometimes changes in the outlook for these two factors can interact to cause counterintuitive movements in asset prices – for example, the stock market can perform well in a soft economic environment as rates fall, creating a positive boost to values that more than offsets the negative drag from cyclically weak corporate earnings. This phenomenon in part describes the strong markets of recent years despite a lacklustre economic backdrop. With the US Federal Reserve now increasing rates and the global economic outlook fairly benign, the general consensus seems to be that there isn’t much scope for further material falls in rates barring a significant deterioration in economic data. As a result, it will be incumbent on corporate profits (cash flows) to grow in order for markets to make significant further progress. With the quarterly reporting season largely complete, how have companies been doing?
With virtually all of the S&P 500 constituents having reported, earnings growth for the first quarter was 13.8%, and revenue growth 7.7% — the best earnings growth rate since 2011 and better than the expected 9%. The energy sector swung from a $1.5bn loss to a $8.5bn, accounting for about a third of total growth. The financial sector had the strongest year over year earnings growth of all sectors at 20%, although the sustainability of this performance is contingent on the path of interest rates going forward. The beleaguered telecom services sector was the only area reporting a decline (-5%), led lower by Verizon which is struggling with a competitive wireless market. Overall, full-year expectations are for S&P 500 revenue growth of 5.4% and earnings growth of 10%. These are solid figures particularly in the context of historically high overall profit margins and persistently low inflation (which prevents companies from increasing prices too freely to create growth).
The first quarter earnings season has certainly exceeded expectations, and qualitative commentary from individual companies has been encouraging. Diversified industrial United Technologies pointed to “good strength” in the US, “recovery” in Europe and “good economic growth” in China. Should these trends continue, it would be reasonable to assume some further upside to stock markets around the world. Looking forward, an increased focus on individual company profit outlooks should at last favour sensible active strategies over passive, since the ‘rising tide’ of steadily declining interest rates has passed. At Cidel, our focus on identifying companies with favourable earnings outlooks not fully reflected in current valuations will keep client portfolios on a solid footing.