Geopolitics will in our view continue to present headline risk for the rest of the year. The US/China trade détente has broken apart as the US administration addresses the prospect of China challenging for dominance in the world economy. This weekend’s military response to the use of chemical weapons in both Salisbury, UK and Syria may for now be described as “mission accomplished” but it remains to be seen what the response would be to any further provocation. At the same time, there has been a run of disappointing economic data in the eurozone. Nevertheless, earnings estimates remain relatively stable for now in aggregate as the recent strength of the oil price leads to upgrades in energy, offset by modest downgrades in other sectors.
In the US, unweighted earnings forecasts for 2018 have in fact inched modestly higher over the last 4 weeks. This is encouraging as it suggests that there has been little direct fallout from US trade sanctions to date. Furthermore, this continues to pin consensus forecasts at a very strong level of 17% earnings growth for 2018 due to the positive effect of US tax reform. This is supporting the scenario in which US markets move sideways and valuations move closer to long-term averages as underlying profits grow.
Within the eurozone, the continued and sharp decline in the economic surprise index since January is notable and appears specific to the region. It is unclear if this is weather-, trade- or Brexit- related. Nevertheless, if GDP forecasts start to fall, the ECB is likely to have to modestly adjust course during this quarter, which would place downward pressure on the euro and may also further widen the spread between US and German 2y yields, which is already at a 30-year record level of close to 300bps.
Declining economic momentum is also visible in unweighted consensus earnings forecasts which have fallen by (a modest) 1% since the end of January. On its own, this does not meaningfully alter the outlook for European equities, with earnings growth still forecast at 8% for the year after this downgrade. However, short-term sentiment is tightly linked to the upgrade/downgrade cycle and the relative local currency performance differential between positively performing US equities and flat-lining European peers remains stark.
In the UK, the unweighted revision index has also softened since January with downgrades to telecoms, pharma and retailers offsetting upgrades in the energy sector. Similarly to the eurozone, this has resulted in a 1% downgrade to 2018 earnings prospects which now also stand at 8% for the full year.
Despite the increase in equity market volatility during Q1, profits forecasts remain robust in our view. In addition, the market reaction to US trade initiatives, Russian sanctions and military events in Syria over the weekend have been modest. We still however believe that we are in a period where markets are de-rating from previously high valuations levels as US monetary policy is re-normalised. Should the deterioration in eurozone economic momentum continue, we believe it would be only a matter of time for the ECB to change tack, leaving the euro vulnerable to a setback against the US dollar following the substantial appreciation of 2017.