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After four consecutive quarters of declining EPS for the S&P (including the estimated 9% plunge in Q1 earnings) is it time to declare victory over the global earnings recession? Here is the answer according to Morgan Stanley’s Jonathan Garner.

Has the Global Earnings Recession Finished?

We think it’s too soon to declare that the global earnings recession has finished and remain neutral equities in our asset allocation framework.

The MSCI ACWI index has risen by 12.7% since the recent trough on February 11 and is now essentially flat year to date. However, it remains some 10% below the peak which was as long ago as the end of last May. The primary determinant of whether the bull market in equities resumes or the rally fades will likely be earnings rather than the multiple. The ACWI trailing P/E is currently around 21x, almost exactly in line with the long-run average since 1988.

The earnings recession in equities began in EM (in local currency terms) in late 2013 and in DM in February 2015. Since then earnings have declined by 14.6% for EM and by 9.5% for DM.

Globally we calculate that earnings are currently falling in 29 of the largest 30 MSCI ACWI markets, with the sole exception being Switzerland. For DM this is the seventh earnings recession since the early 1970s. If it ends now it will tie for the least severe in percentage decline terms and win for being the shortest in months of duration of the last 45 years. The longest earnings recession was that which ran from August 1989 to June 1993 while the deepest was the 60% decline in earnings during the GFC.

Morgan Stanley pegs the risk of global economic recession at 30% currently. Five of the prior six earnings recessions were associated with economic recessions in DM, but one was not. That was the earnings recession triggered by the Asian Financial Crisis. It lasted from April 1998 to June 1999, with earnings falling by 10% peak to trough, approximately the same decline as has occured in DM so far.

In EM the current earnings recession, although not the deepest — the Asian crisis holds the record with a 56% peak to trough decline — is already the longest by far. The earliest markets to go into earnings recession were Brazil and Russia, with China and Taiwan the latest.

So what next? For the S&P 500 our top-down forecast is that earnings rise by 4% (after falling by 1% last year). We project earnings to decline by 5% in Europe (after already falling by 5% last year) and a decline of 6% in Japan (reversing a rise of 6% last year). Meanwhile, we project the EM earnings recession to drag on with another decline in EPS of 7% in 2016 (after falling by 19%, last year).

Thus, for around half of ACWI we project declines in earnings in 2016, with the other half (i.e., the US equity market) having a better outlook. This distinction in forecast earnings trends is one key reason why we rank the US equity market as our top pick in global equities. Year to date estimate revisions from bottom-up analysts globally have stabilised somewhat in the US and EM, but have weakened markedly in Europe and Japan. This is unsurprising, given the pattern of US dollar weakness, EM FX and commodity price recovery and euro and yen strength that has been in place recently. We expect yen strength to be a persistent headwind over the medium term for Japan corporate earnings, but for EM and the Eurozone we expect currency weakness to reassert itself (a negative for EM earnings but a positive for Eurozone earnings, given the sector composition of these indices).

Uncertainty over earnings means we and investors will be watching the next earnings season with interest. It kicks off with Alcoa this coming Monday. A particular focus is the interplay between potential pressure on financials earnings and potential recovery, in energy, materials and industrials Mid Economy’ cyclicals). Financials is the largest sector in ACWI, accounting for 20% of market cap, but the combined energy, materials and industrials universe accounts for a similar percentage at 22%. We estimate that ACWI financials earnings grew 7% year on year in 2015 while the combined Old Economy cyclicicals industries in aggregate had an earnings decline of 29%. Style-wise we continue to prefer high free cash flow yield and dividend yield stocks in all geographies, given our cautious view on growth and call for core government bond yields to remain low. Within the US equity market we prefer utilities over staples, healthcare over technology and financials over energy.

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