As we’ve reached the end of corporate earnings season in the US and other major markets, it’s interesting to see what conclusions can be drawn from companies’ reports. The travails of some sectors are well known. Energy companies for instance have understandably been struggling with low oil prices, and a lot of banks around the world haven’t fared well when faced with low interest rates, cautious customer bases and volatile trading environments in financial markets.
However, the rate of profit growth of companies operating in a number of different industries around the world has been slowing for some time as the economic cycle matures. While we have often read of different companies exceeding analyst expectations when they report results, often that has been a result of these expectations representing very low hurdles.
So what does this mean? The problem is that with monetary policy having simultaneously helped to inflate capital markets across the board and compress the future returns available on safer assets by anchoring yields on high quality government and corporate bonds, stock markets in places like the US have begun to look quite expensive. The price that people are willing to pay for the prospect of cashflows generated in the future has risen substantially. This in turn means that investors are implicitly betting that the profits that companies make in the future will continue to grow meaningfully in order to justify these prices.
Previously, during periods where earnings looked vulnerable and concerns of economic slowdown came to the fore, markets took solace from more monetary intervention. Now however, as some major central banks around the world are giving the impression that they’re running out of ammunition and the Federal Reserve desperate to inch further away from its record low rates, growth in activity might have to be driven either by more supportive fiscal policy around the world or by improvements to productivity – and there are doubts over the potential for both.
How does this impact portfolios? As investors, we are wary of markets where valuations are challenging, like the US. We’re optimistic for returns further down the road, but we do need to be aware of the likelihood of some volatility as well.