Equity markets have remained volatile as mixed economic data, funding concerns in the eurozone, M&A activity and corporate results have left plenty of unanswered questions.
One of our key reasons for being tactically overweight developed markets equities remains valuation. The S&P 500 is trading at about a 25 per cent discount on a forward price-toearnings basis versus its historical average.
This discount implies that the market is now putting very little faith in the earnings forecasts that make up the denominator in this equation.
Essentially, the market is saying that the full-year forecasts are about 25 per cent out of kilter with the reality. We do not agree.
An important driver for earnings growth this year has been the ability of corporates to expand revenue (in the low teens for the S&P 500). Margin expansion through cost management and share buybacks is helping the earnings line grow at an even faster rate.
The first point to note is that we are close to three-quarters of the way through the year and if earnings were set to fall off a cliff, as the market seems to be assuming, we would have expected a far greater number of profit warnings than there have been.
In fact, in the US, earnings estimates for the full year are still rising following a very strong earnings season, accompanied by cautious but broadly positive management outlook statements.
For its part, Barclays Capital has end-of-year forecast earnings for the S&P 500 of $96 (15 per cent earnings per share growth) and $105 for 2012 (9 per cent growth), slightly below current consensus expectations.
Admittedly, the earnings season in Europe has provided less reassurance, with forecasts for the full year having been cut so far by 200 basis points.
We would attribute this to three key reasons – deeper austerity measures, currency impacts and a smaller technology sector relative to the US.
For the full year, expected earnings growth in the US is mostly expected to come from technology, energy and materials stocks. There can be no doubt that earnings in these sectors are economically sensitive. However, they also have the greatest percentage exposure to emerging market demand growth, which for the moment, remains reasonably robust.
Another major constituent of expected growth is consumer services and the news from the world’s most important consumer marketplace, the US, has so far been tentatively positive in the third quarter, with retail sales registering the most growth seen in four months.
There are plenty of potential pitfalls at the moment, with concerns over European banks’ funding joining a long list.
However, we still believe that the earnings growth we are likely to see from corporates this year will eventually foster a significantly higher valuation for equity markets.
Henk Potts is equity strategist at Barclays Wealth