US 2Q earn­ings favour in­dus­tri­als

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

As the sec­ond quar­ter US earn­ings sea­son winds up, the dom­i­nant pic­ture is of stronger sales and faster earn­ings growth. That’s handy. In the early stages of this five year bull mar­ket, it was cen­tral bank liq­uid­ity that pushed eq­uity prices higher. Then over the last two years, mul­ti­ple ex­pan­sion took over. Now, with valu­a­tions back in line with fair value, top and bot­tom line growth are emerg­ing as the mar­ket’s main driv­ing force.

With more than 450 of the S&P 500’s com­pa­nies now hav­ing re­ported, 2Q14 sales are up by 4.3% year-on-year, com­pared with an av­er­age of 2.2% over the pre­ced­ing four quar­ters. Mean­while, earn­ings have risen 9.9% YoY, com­pared with a 2Q13–1Q14 av­er­age of 5.4%. Profit mar­gins re­main el­e­vated at 9.4%, defying the ex­pec­ta­tions of the mar­ket bears. This co­in­cides with our view that profit mar­gins should re­main com­fort­ably high. At this stage in the cy­cle any pres­sure on profit mar­gins is most likely to be ex­erted by an ac­cel­er­a­tion in em­ployee com­pen­sa­tion. How­ever, as we have ar­gued be­fore, the im­pact of ris­ing wages is likely to be smaller than gen­er­ally ex­pected.

Look­ing for­ward, given the favourable house­hold lever­age sit­u­a­tion and an im­proved labour mar­ket-sup­ported by the sec­ond quar­ter’s strong growth in GDP-we are op­ti­mistic about growth prospects for the sec­ond half of the year. As a re­sult, we fully ex­pect to see even stronger sales and earn­ings growth over the com­ing months.

Bar­ring neg­a­tive sur­prises, that means the next phase of the re­cov­ery is likely to see a pick-up in cap­i­tal spend­ing by busi­nesses. It shouldn’t take long to ma­te­ri­alise. Usu­ally US busi­ness cap­i­tal spend­ing lags sales growth by just one quar­ter. En­cour­ag­ingly, the ISM man­u­fac­tur­ing PMI-the prin­ci­pal lead­ing in­di­ca­tor for busi­ness cap­i­tal spend­ing-rose to 57.1 in July, stronger than the ex­pected 56. As ris­ing sales be­gin to squeeze ca­pac­ity, it will not take com­pa­nies long to start shop­ping for new plant and equip­ment, or even to con­sider set­ting up new fac­to­ries to meet the ris­ing de­mand.

The ob­vi­ous ben­e­fi­ciary of this ex­pected re­cov­ery in US cap­i­tal spend­ing will be the in­dus­trial sec­tor. The ISM man­u­fac­tur­ing PMI tends to lead busi­ness cap­i­tal spend­ing by around eight months, and year-on-year growth in the S&P 500 in­dus­trial sec­tor’s trail­ing 12-month sales per share by 14 months. This re­la­tion­ship makes sense, as it is in­dus­trial com­pa­nies which pro­duce the nuts and bolts needed for a broader ca­pac­ity ex­pan­sion.

A turn-around will not be be­fore time. So far this year, the S&P 500 in­dus­trial sec­tor in­dex has un­der­per­formed grievously, de­clin­ing -0.7%; the worst per­for­mance of any sec­tor ex­cept con­sumer dis­cre­tionary stocks. The flip-side of that un­der­per­for­mance is that valu­a­tions look rea­son­ably at­trac­tive. The sec­tor’s price to 12 month for­ward earn­ings ra­tio and price to book value ra­tio are both around their his­tor­i­cal me­di­ans.

With in­dus­trial com­pa­nies’ sales and earn­ings set to im­prove as cap­i­tal spend­ing re­cov­ers, P/E ra­tios in the sec­tor look likely to fol­low their his­tor­i­cal pat­tern, ris­ing rel­a­tive to the ra­tio of the over­all eq­uity mar­ket as busi­ness cap­i­tal spend­ing picks up. In such an en­vi­ron­ment, the S&P 500 in­dus­trial sec­tor in­dex should out­per­form the broader in­dex.

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