ESN Value Monitor
Over recent years, corporate earnings have benefited from major sustained structural forces . Globalisation, free trade, migration, the opening of China, technology advance, the spread of capitalism, etc have greatly enhanced the supply and productivity of labour on a worldwide basis progressively since around the mid 1990's. The bargaining power of capital relative to labour has therefore seen major sustained improvement and margins / returns on capital have expanded accordingly. In the current global economic expansion, earnings have again been benefiting considerably from the combination of structural margin expansion and renewed cyclical growth in global demand (albeit erratic and geographically uneven).
In the established environment of increasingly free and efficient global markets, it is inevitable that market forces would eventually compete margins and returns back down to the long run required levels , whereupon earnings would structurally revert to the long run trend line. On the assumption that the forces of globalisation etc are unlikely to go into reverse, it would take ongoing reflation of the global economy to achieve such structural mean reversion. Global final/consumer demand would have to expand to the point where global labour markets tighten sufficiently to allow labour to claw back some pricing power at the expense of capital. Meanwhile, the outlook needs to be bright enough to tempt the global corporate sector to more aggressively chase the supernormal returns on offer by stepping up capital spending to create sufficient new capacity to eventually compromise the pricing power of capital relative to labour. Periods of cyclical economic weakness such as the recent “great recession”, when worries focused on the risk of demand deflation, put earnings under significant downward cyclical pressure, but also delay any structural mean reversionary process because they weaken the labour market while restraining investment in new capacity by the corporate sector.
The success of companies in aggressively managing costs and defending margins in the recent recession suggests that the structural environment is still quite favourable for earnings as they recover cyclically with capital maintaining pricing power at the expense of labour . US earnings had recently been recovering surprisingly quickly from their headlong collapse below the 32-year trend line. They are already back well above trend but are now suffering from more recent deceleration in the economy. However, they can yet make new highs if, as we expect, the economy continues its cyclical recovery. European earnings are once again under recessionary pressure due to the Eurozone debt crisis, but will ultimately be governed by the same global structural and cyclical forces that pertain to the US.
Eoin Treacy's view Corporations have demonstrated their ability to contain costs and drive efficiency gains since the onset of the credit crisis and this has translated into margin expansion which has flattered earnings. The rebound in earnings has helped drive a relative compression in P/E ratios despite the S&P500 more than doubling since 2009. With earnings now close to historic peaks it is reasonable to ask how sustainable this trend is. As it becomes increasingly difficult to wring additional benefits from such rationalisations, a more broad based recovery will probably be required to sustain earnings momentum.
The fiscal cliff continues to grab headlines but the rebound in stock markets over the last three weeks suggests the benefit of the doubt is being given to an agreement. If the rebound in housing continues and unemployment figures improve further, there is potential for earnings to improve but they are likely to become increasingly dependent on growth.
At this stage, Europe represents an interesting proposition. The charts in the above report depict a rather depressing situation where earnings have, on aggregate, been deteriorating and are below trend. The issues Europe is presented with are neither fleeting nor trivial; however one has to query how much these concerns have been amplified by negative perceptions of future cohesion. If as appears likely, the Eurozone is prepared to do what is necessary to hold together, then there is additional potential for a rerating of stock market potential.
The Stoxx 600 Index found support in the region of the 200-day MA from late November and hit a new 17-month high this week. A sustained move below the MA would be required to question medium-term scope for continued upside.