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Earnings to the rescue
Equity markets slipped off record highs in the second quarter, amid sticky inflation and reduced expectations of central bank rate cuts. Yet earnings came to the rescue. A solid set of first-quarter numbers overall helped bolster stock markets even as macroeconomic conditions continued to cause volatility.
U.S. earnings outshone those in Europe. European Q1 earnings dropped 8.5% year on year, while earnings in the U.S. grew 3%.1 Yet Europe still came in ahead of expectations, and earnings estimates continue to rise for both regions.
One interesting observation of this earnings season has been the difference in market reaction between those companies that beat expectations, versus those that missed. In Europe, the gap is at a historic peak. See the chart. We believe the market’s strong reaction to earnings results highlights the importance of fundamental research and stock selection in this new era of higher inflation and rates. Equity markets can perform well when rates are at these levels, but earnings increasingly matter, in our view. We believe this calls for an emphasis on quality companies able to deliver on earnings, regardless of what central banks decide to do with interest rates.
Defining quality
There are many definitions of “quality,” but at BlackRock Fundamental Equities, we believe companies should meet various criteria to earn the quality label, including: high return on capital, opportunities to deploy capital at high levels of incremental return, good profitability, excellent management teams and conservative leverage. We believe these attributes give companies the potential to consistently beat market expectations for their earnings – and may mean that valuations don’t reflect that long-term potential.
Long-term growth, short-term efficiency
Many of the companies globally that delivered strong earnings numbers in Q1 benefit from long-term earnings drivers – or mega forces – and at the same time have found ways to cut costs and improve margins. This is evident in the technology sector, where many quality companies are investing to capitalize on the rise of artificial intelligence (AI), and are also improving operating efficiency and paying dividends for the first time.
Building a more efficient future
The transition to a low-carbon economy is another mega force that’s set to power earnings long into the future – and the Q1 results showed this is also a theme for now. Buildings account for 40% of global carbon emissions, with three-quarters of this driven by heating, cooling and lighting.2 Some of the quality companies that provide energy efficiency solutions in these areas performed well in Q1 – and are well placed to deliver strong earnings over the long term as governments and companies race to hit net-zero targets. Any improvement in global economic growth may provide a further near-term boost.
Timeless delivery
Not all quality companies are linked to an identifiable mega force. Some of the best consumer companies have developed their own long-term growth drivers – timeless brands that don’t go out of fashion. Some of the highest-quality luxury car and fashion companies in Europe – with prestige brands and order books that are full well into the future – managed to grow both revenues and profits in Q1, even as overall luxury spending softened. We believe this makes their earnings resilient even during periods of weaker economic growth.
The Q1 earnings season highlighted the importance of selectivity, in our view, with “quality” companies showing that they can deliver – even if rates remain elevated – while also investing for future growth.3
Sources:
1 Barclays Research, May 2024
2 World Green Building Council, September 2021
3 All views are from BlackRock Fundamental Equities as of May 15, 2024
