The first quarter of 2018 saw companies around the world report very strong earnings growth, but the market wasn’t interested, focusing on the outlook and risks that lie ahead. What should investors make of this?
In aggregate the largest companies in the US, represented by the S&P500 index, reported 25% year-on-year earnings growth in the first quarter of 2018. To put this into perspective, this was the highest level of growth achieved since the recovery from the financial crisis in 2010. Even if we exclude the benefit from President Donald Trump's corporate tax reforms, the growth would have been about 18%, driven by strong US and global economic growth, and helped by depreciation of the US dollar.
Reported earnings growth was similarly strong outside the US, with companies in Europe reporting 8% year-on-year earnings growth, despite facing foreign currency headwinds as the euro appreciated. Japanese companies reported 12% earnings growth and in China, excluding companies in the financials sector, growth was 23%.
Even if we exclude the benefit from President Donald Trump's corporate tax reforms, the growth would have been about 18%
Unusually in such a strong earnings environment, the markets remained broadly flat during earnings season and our observation was that the reaction at the individual company level was also underwhelming. In the US market, company 'beats' versus consensus expectations were bigger than normal, but the price reaction to those beats was smaller than normal.
Our interpretation of this market reaction is twofold: First, we believe that the market had largely anticipated these strong results and indeed the markets had seen a strong rally in the latter part of 2017 culminating in the equity market peak at the end of January 2018. In the US market, the Trump tax reform was well understood and analysed, and had already been priced into company valuations.
Second, investors were focusing more on the outlook and risks that lie ahead. Economic growth appears to have peaked, in particular outside the US, and investors are also increasingly recognising the threats from higher interest rates as central banks end quantitative easing and normalise interest rates, and from the geopolitical risks associated with Trump’s foreign policy agenda.
Digging into the detail of the reported results from companies, we asked ourselves a couple of questions: 1) Could we see signs of wage pressure and inflation? No, other than for companies buying commodity inputs. 2) Could we see signs of US companies repatriating and using their overseas cash? Yes, buyback announcements in the US hit record levels and M&A activity accelerated further.
Apple, Amazon, Alphabet, Microsoft and Facebook combined increased their capital expenditure 91% in Q1
And what surprised us? US companies raised their capital expenditures by a surprising 20% year-on-year in aggregate. Astonishingly, the largest five companies were responsible for a third of this growth on their own. Apple, Amazon, Alphabet, Microsoft and Facebook combined increased their capital expenditure 91% to $20.3bn in Q1, spending almost as much as the $25.5bn invested by the capital intensive energy sector.
So while Q1 earnings were strong, it appears that the market had largely discounted this in advance. That said, the high levels of capex, particularly in the US technology sector, were notably higher than expectations.
The Hong Kong dollar is tied closely to the US dollar. Monetary policy made in Washington therefore applies directly in Wan Chai and Kowloon. In recent months, the Hong Kong Monetary Authority has been obliged to shrink its balance sheet rapidly to maintain the fixed exchange rate. This serves as a real-life policy experiment of the effects of quantitative tightening in a financial system. So far, nothing has blown up, but Hong Kong equities have been under pressure as financial conditions have tightened.
Without adjustment on the home front, we believe that President Donald Trump's push to reduce the trade deficit is unlikely to improve the US trade balance, or boost domestic employment and growth. However, his outspoken approach and questioning of the prevailing trade system may be the very jolt that global trade negotiators need to update their thinking and move ahead with a constantly changing global economy and patterns of trade.