Higher profits please

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Good morning. Magnolia trees are blooming in New York City, baseball season has begun, and young hearts everywhere are turning to love. That's right: Q1 earnings season is here. Major banks begin reporting on Friday. The news will be good. But maybe not as good as it should be (see below). Meanwhile, email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Why aren't earnings estimates rising?

This is a strong economy. We are on track to grow at 2.5 percent in the first quarter, according to the Federal Reserve Bank of Atlanta's GDP Service, which is above the long-term trend and an impressive addition to our strong growth record. Last week's manufacturing survey numbers showed a return to expansion, and Friday's jobs numbers only reinforced that point. A net 303,000 jobs were added in March, widely distributed across sectors. Working hours rose, defying recent expectations that labor market weakness lurked beneath the surface.

Against this economic backdrop, it expects similarly strong earnings growth. But judging by bottom-up analyst estimates, this is not happening. Analyst consensus has S&P 500 EPS rising just 3 percent year over year in the first quarter. As Robin Wigglesworth pointed out in Alphaville last week, the story outside of Mag 7 doesn't seem terribly strong. Excluding the 10 largest S&P stocks, earnings per share are expected to shrink 4 percent in the first quarter, according to Goldman Sachs calculations. This is partly due to the expected sharp contraction in energy revenues of 27 percent. But the weakness exists elsewhere as well. EPS for materials is expected to decline by 24 percent, and for cyclically sensitive industries to rise by only 1 percent (during a period of supposed improvement in the manufacturing sector, no less).

One way to solve this problem is to say that earnings estimates are too bearish. This makes sense, simply because earnings estimates have been very bearish for a while. The chart below from Goldman explains it well, with actual results in light blue and historical estimates in dark green:

Pinky Chadha of Deutsche Bank recently issued a more upbeat forecast for S&P earnings, partly in recognition of the strong macro data. Take industrial cyclical stocks (except for a few stocks affected by the pandemic), where first-quarter estimates pointed to flat earnings growth. Chadha expects something closer to trend growth over the long term, implying a 4 percent increase in earnings per share in the first quarter. Overall, his team expects earnings growth of 9 to 10 percent, which represents a historical average for earnings. With economic growth at 2.5 percent, this all seems reasonable.

The more pessimistic view is that the bottom-up estimates are correct, because the top-down view ignores some unpleasant economic developments. In recent weeks, more companies have signaled early signs of slowing consumption. Costco shares have fallen 9 percent since the company missed sales expectations in early March. McDonald's price fell by a similar amount. Last month, its executives warned of a decline in low-income consumers. Maybe they see something in the margin that doesn't fully show up in the macro data. S&P 500 spreads, which have not fully returned to pre-pandemic levels, could suffer if the consumer loses more power.

But this is a long-term fear. In the past, this proved to be exaggerated because the distress remained confined to low-income consumers. It is possible that a strong American economy as a whole can coexist with deterioration at the bottom. But with earnings season approaching later this month, investors will be eagerly looking for signs that pain is working its way up the income ladder. (Ethan Wu)

The bargain hunt is moving to Europe

As a value guy, this chart makes me a little crazy:

We recently talked at length about how UK stocks have become strangely cheap compared to US stocks. (Or are US stocks just weirdly expensive?) The same is true of Europe more broadly, and to a slightly less extreme degree. As you can see, since 2015 or so, large European stocks have gone from a small, stable discount to a huge and ever-increasing discount. Why should this be? The difference becomes even stranger when we look at Europe as a whole, a market that is larger, deeper and more diverse than the UK.

As in the UK, part of the valuation gap in Europe is due to sector weights. The S&P 500 is much heavier on ICT, due to the influence of very large technology companies, and lighter on most other things:

But the gap is not limited to big technology companies only. If you take the Magnificent 7 of the S&P 500, its multiple moves are from 22 to 19. The S&P 350 is at 14.

Perhaps most important is the fact that the United States receives a premium over Europe in every sector except one – even relatively slow-growing sectors such as financials, energy, utilities, and materials. In fact, in the fastest-growing field of information technology and healthcare, trade between the United States and Europe is approaching parity. In the European technology sector, you can attribute the higher P/E to the heavy weighting of expensive ASML and SAP, which together make up half of the sub-index. Novo Nordisk has a similar impact on healthcare:

Here's the tricky thing, though. In almost every sector, US large-cap companies have significantly outpaced those in Europe over the past 10 years – a period during which the premium in the US has grown. I have omitted financial data because long-term growth data for the sector is spotty due to mergers:

The huge gap in telecom growth rates is due to the fact that in Europe this sub-index consists almost entirely of mature mobile telecommunications industries. In the US, it includes Meta, Netflix, and Alphabet.

The gap in valuations between the US and Europe looks less impressive when you look at the gap in historical growth (of course, it's future growth that really matters for valuations, but the record tells you something). But it still looks great. Interestingly, for example, Europe trades consumer staples and industrial goods at a notable discount, but has shown very similar growth. These may be the areas to look for deals.

One good read

More on McKinsey's very poor study on leadership diversity and financial returns. Criticisms have been accumulating for years. As far as I know, McKinsey has not responded, which is strange.

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