Against all the odds, the European economy has finally awoken. The improvement has been confirmed by numerous quarterly earnings reports across a very broad range of sectors (hotel industry, consumer goods, construction, manufacturing, IT services). French unemployment even fell in March, although the decrease can hardly be defined as a sustained trend or a windfall. However, earnings forecasts have still not yet been revised upwards. At best, we observe that downgrades are in the process of stabilising. As a result, the recent equity market rally has driven valuations to more demanding levels (16x 2016 PE for the DJ Stoxx 600 and 17.6x for the S&P 500). 2016-2017 earnings momentum will therefore now have to resume an upward trend to rekindle hope of a decidedly bullish market performance (including dividends).
The situation in the US is far more complex to analyse. Although the economy has certainly avoided tipping into recession, a bottom-up analysis of corporate performance is nonetheless disconcerting. Available cash via cheap debt has been used chiefly to finance dividend pay-out, share buybacks and mergers & acquisition deals as a means of stemming declining profitability. According to Standard & Poor’s, companies spent almost $376bn on acquisitions, which is 40% higher than in 2007. America Inc.’s gearing has increased 30% compared to last year and has now reached the same level as in 2007, whereas operating cash flow has diminished over the same period. On a graph, when these two curves diverge like the box of an expanding accordion, the risk of an economic and/or financial correction increases. The intriguing behaviour of US companies explains the Fed’s reluctance to hike rates too quickly or to steeply.
However, no economic system can be sustained with debt increasing while reimbursement capacities diminish. Over the past few weeks, the most bearish scenarios have evaporated. Nevertheless, certain key issues will have to be watched closely (US corporate debt, political risk in Europe, sluggish Chinese growth) as these factors could derail European equity markets, which are currently benefitting from less-negative economic momentum than expected. In short, economic and stock-market predictions remain as challenging as ever.
The American economist John Kenneth Galbraith observed with humour that “the only function of economic forecasting is to make astrology look respectable”, a point of view which the great soothsayer Nostradamus would surely have appreciated.
Igor de Maack, Fund manager and spokesperson at DNCA. This article was finalised in April 29th, 2016.
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