What’s going on in equities?

2011 estimates of corporate earnings fell consistently from August last year straight through the Q411 earnings season and despite 10% revenue growth, margins disappointed, resulting in sub-7% growth. Analysts had expected 2012 to be a year of decent recovery, but aggregation of sell side analysts’ forecasts now shows 2012 earnings growth at just 5.4%, as against the expectation of 10.6% prevailing as recently as June. This halving of growth forecasts has been broad, affecting all regions and most sectors, and has also been achieved at a steady rate. Consensus forecasts for both 2012 and 2013 have been cut in virtually every month since Aug 2011, but it is apparent that the pace and magnitude of earnings cuts is moderating, so whilst downward revisions may be expected to continue for now, the worst of the 2012 earnings downgrade cycle does appear to have passed.

Inflection points matter for markets and it is noteworthy that equity markets have rallied despite the deteriorating growth picture. The key driver here has been the European Central Bank’s proposed interventions into sovereign bond markets, which have, at least for the time being, supported a surge in risk appetite and there have been additional asset purchase commitments by other central banks, including both the US Federal Reserve and the Bank of Japan.

We may now also see some  stabilisation in leading indicators, which should allay fears of further economic deterioration through the fourth quarter, and this is important because with deteriorating near term fundamentals as evidenced by the news flow and analysts’ downgrades, sentiment is key to re-valuation of markets. Thus, the recent rally, in combination with further earnings deterioration, has involved the price/earnings multiple of the global equity markets rising from the level of 11.5 times recorded back in June, to the current multiple of 13.1x. This can also be expressed as the earnings yield on equities falling from 8.7% to 7.6%.

Digging into the details, global corporate revenues are broadly expected to grow by 5.0% and 4.8% for 2012 and 2013 respectively, as against expectations for 6.1% and 4.7% growth back in June, and down from the 10% growth seen in 2011. Cuts in forecasts involve every region except for Canada and nearly every sector, with only Consumer Staples holding up, reflecting its defensive nature. Technology and Energy have seen particularly significant cuts – indeed Energy sector revenues are now forecast to contract modestly in the US, Europe, and Canada.

As for corporate earnings, global estimates for 2012 have fallen as the global growth backdrop has deteriorated and major downgrades have been seen in commodity sectors and Technology, and only the Health Care, Consumer Discretionary and Utility sectors held their ground. At the country level, Japan’s earnings growth is largely a function of base effects given last year’s tsunami and related impacts but weaker economic growth and fading reconstruction-related activity have led to lower forecasts, whilst European earnings expectations have fallen sharply to 3% from over 10% and UK earnings are now forecast to contract versus earlier mid single digit growth. Emerging Market forecasts have fallen to 6.1% from 13%.

The fact that earnings numbers are expected to fall harder and faster that economy-level data reflects the challenge that net margins have fallen, with a downgrade of 30bps to the net margin expectations for 2012 seen over the last three months. Margins contraction in the Materials sector has been the most pronounced – and has driven most of the earnings downgrade for Canada and GEM, across regions. Technology has also seen a significant reduction in margin forecasts. The only sector to show stable margin forecasts has been Health Care. For 2013, margins are expected to expand by 60bps across all regions and sectors. This looks optimistic and a primary source of risk for the current 2013 earnings growth forecasts, which appear high in the context of big picture developments.

Turning to market valuation, the shift in terms of the 2012 pricing is also seen for 2013, with the price/earnings ratio moving to 11.6x from 10.9x over the last quarter, with a combination of rising markets (higher ‘p’) and declining earnings estimates (lower ‘e’). At the regional level, Europe and GEM trade at a discount to the world on both 2012 and 2013 estimated PE multiples, while US, Japan and Canada continue to trade at a substantial premium. All sectors have shown a multiple expansion over the last few months.

In terms of price/book value ratios, global equities currently trade at 1.7x book value, versus 1.6x three months ago and this expansion reflects the market’s summer rally, itself a function of falling risk premia. With scepticism over sustainable earnings power and a persistently difficult regulatory environment, the Financials sector trades at the lowest P/B ratio among sectors (1.1x), and Japan trades at a low among regions (1.0x). With high RoE driven by near-record margins, the US continues to trade at a substantial premium to the World on P/B and both the Tech and Healthcare sectors stand at premia to the market overall.

With regard to Return on Equity (RoE), sharp downgrades to earnings expectations have naturally involved lower Return on Equity (RoE) estimates, and estimates for global RoE for 2012 are down from 13.6% in June to 13.1% now. RoE is expected to rise in 2013, driven by expectations of higher margins, and big gains are expected in the Materials and Consumer Discretionary sectors, and in regional terms, Europe, Japan and Canada. Since June, estimates for RoE in 2012 have fallen particularly in Europe ex UK, and at the sector level, Materials suffered the most substantial decline in estimates, from 14.9% to 12.6%.

Dividend yields for markets overall have fallen slightly to 2.9% from 3.0% over the past few months, with yields above 4.0% for Pacific ex Japan (primarily Australia) and US yields at 2.1%. Among sectors, Technology continues to be low at 1.5%, while the Telcos and Utilities sectors each exceed 4% yields. Estimates for dividend growth for 2012 presently stand at 6.3%, well above earnings growth forecasts. This may not surprise given low balance sheet leverage, high cash balances, strong cash flow, and low payout ratios. Thus the Tech sector has the highest forecast dividend growth rate among sectors, and currently the lowest yield and the lowest payout ratio among global sectors. At the regional level, the US and Canada are expected to lead, while Europe is forecast to lag. This is largely due to a few already-announced cuts in the Telcos and Utilities sectors but with the payout ratio close to a 30 year low in Europe, we firmly expect dividend growth to resume in 2013.

As ever stock selection is important – but stylistically companies that offer decent growth, sustained profitability, and with conservative balance sheets and strong current free cash flows, supporting high and rising dividends, look well placed to reward patient investors, so long as the entry price is not excessive – and that does require long term investors to be prepared to invest when valuations are still modest, discounting some ongoing uncertainties.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla