In Defense of Sitting Tight

by Joe Amato, President and Chief Investment Officer—Equities, Neuberger Berman

Earnings disappoint again, but markets stay resilient.

With the U.S. party conventions out of the way and Hillary Clinton polling more strongly, investors may divert their attention, at least for a while, away from politics to focus on economic and company fundamentals.

If they do, will they subscribe to Republican presidential candidate Donald Trump’s view that they should follow him and sell out of equities?

Markets Have Been Remarkably Resilient

They’d have to reckon with just how resilient markets have been lately. Equities bounced back from Brexit at the end of June. They even sailed through July’s bear market in oil, which briefly slipped under $40 per barrel last week.

At the beginning of the year, the oil price was one of the major factors driving extreme risk aversion. This time, the impact has been muted. Even energy sector high-yield spreads are pretty much where they were when oil hit its recent high at the beginning of June.

Still, underneath these low yield-supported valuations the economy remains sluggish. As last Friday showed, the U.S. continues to post healthy jobs data. And yet the second quarter U.S. GDP print seriously undershot expectations at 1.2% real and 2.4% nominal growth. You have to go back to the first quarter of 2010 to find a report that weak. Household spending was strong and a lot of the weakness came from inventories being run down, but it wasn’t so long ago that economists were forecasting 3% real GDP growth for the second half of this year.

Three-quarters of the way through the second quarter reporting season, we can see that this is a tough environment in which to eke out earnings growth.

Another Weak Earnings Season

Year-over-year, we are on course for a 2% drop in earnings. Take out the energy sector and earnings are up around 2%-3%. That would be false comfort, however. A year ago, the consensus estimate for 2016 S&P 500 earnings per share was $130. Three months ago it was around $123. Now, we’ll be lucky to make $118. That was what U.S. equity investors got in 2014 and 2015, too; three years of flat earnings suggests this isn’t just about oil, but low investment across industry in general.

It’s a similar story in Europe. We’ve pointed to the quiet outperformance of European macro data over recent months, and both second quarter GDP growth and July inflation data came in ahead of expectations. Corporate earnings have been even weaker than in the U.S., however. We are looking at double-digit year-over-year declines for the second quarter.

It’s true that, if we strip out Europe’s banks, we might expect earnings growth of 3%-4% overall. However, stripping out banks in Europe is even more questionable than stripping out energy companies in the U.S. These banks lost a third of their value between the two stress tests of 2014 and 2016 and remain poorly capitalized, weighed down by nonperforming loans and overexposed to sovereign credit issues, which, in an economy as dependent on bank credit as Europe’s, is a serious impediment to growth.

Mixed Signals Create ‘Confused Apathy’

To sum up, the slight improvement in corporate earnings over the last couple of quarters cannot disguise how disappointing the figures are, given the easing off of the China, oil and, for U.S. companies, strong-dollar headwinds that we have been describing since the spring.

A phrase I have heard to describe investment psychology at the moment is “confused apathy.” Active managers struggle to generate alpha; beta looks tired, stretched and expensive; bond yields are incredibly low; the political environment is unpredictable. But wasn’t that what we were saying two years ago when the S&P 500 was 15% cheaper and earnings were exactly the same?

In other words, this is not an ideal way to invest, given the long-term, common sense correlation between earnings and market valuations, but ordinary investors that are patiently trying to grow their wealth arguably can ill afford to ditch equities, especially with bond yields so low. Monitoring risk is sensible, but trying to time this market makes about as much sense as, let’s say, building a wall around Mexico.

Copyright © Neuberger Berman