Earnings have been on a downtrend since the global economic expansion lost momentum in the second half of 2018. To date, the trailing earnings per share (EPS) growth of the S&P 500 Index has shrunk to a meager 1.6% year on year, while on the MSCI AC World Index, it has actually fallen by 0.6%. Meanwhile, global equities have risen by a whopping 17.6% in the 12 months to the end of November.

“Clearly, we have been experiencing a ‘zero earnings growth’ bull run lately,” says Van der Welle, a strategist with Robeco’s Global Macro multi-asset team. “It begs the question whether the apparent blissful ignorance of the peak in earnings in the rearview mirror matters at all for an aging bull market going forward.”

“Currently, we are in the decelerating segment of the US corporate profitability cycle, as US corporate tax cuts benefits have faded, while unit labor costs have risen. Profit margins are still at decent levels, but the consistent downtrend bears striking similarities with the late-cycle behavior that has preceded previous US recessions.”

Van der Welle says it is important to look at the peaks and troughs in trailing earnings growth – the profits reported over a past period – and compare them with projections for forward earnings growth to get a better idea of what might happen next. US trailing EPS growth peaked in Q4 2018 against a backdrop of escalating trade tensions between the US and China, but may not yet have troughed.

“Financial markets are forward looking and typically anticipate the next phase in the business cycle,” he says. “Major market movements often precede major inflection points in the cycle. Therefore, with hindsight, one may observe that the market rout which erupted in early Q4 2018 was already instigated by the anticipated peak in S&P 500 earnings and the expectation of an overall subsequent earnings growth deceleration taking shape in 2019.”

“However, in waiting for reflationary forces such as more fiscal and monetary stimulus to appear further down the road, this market has defied the downtrend in earnings during 2019.” This is shown in the chart below, with the weighted trailing EPS of the S&P 500 clearly falling while the index itself keeps on rising.

“The question is how long a bull market can withstand such a downtrend in the earnings environment, and the answer is not indefinitely,” says Van der Welle. “Our analysis of the last ten major peak-to-trough moves in the S&P 500 12-month forward earnings figures shows that equity market returns were negative on average (-0.6%) 12 months after a peak in forward earnings.”

“However, not every earnings downtrend is created equal with respect to its equity market impact. There is a distinction to be made between a recessionary and a non-recessionary earnings downtrend.”

“For example, the recessions that occurred from October 2000, November 2007 and June 2008 all coincided with deepening market sell-offs. But the other peak-to-trough forward earnings trajectories (in 1995, 1998, 2002, 2014, 2015 and 2018) all saw equity markets move higher instead.”

So, what does this mean for markets? “Our base case is that we are likely to see reflation in 2020, and are therefore currently experiencing the non-recessionary earnings slowdown variant,” says Van der Welle.

“Our US yield curve-based recession indicator points to a 30% probability of a US recession in 2020, leaving us positive on equities. With a 70% implied probability of an extension of the cycle, the odds favor equity markets making new highs.”

“In summary, the current environment of declining corporate profitability may not necessarily usher in a bear market. But tactical caution is needed, even if we are seeing the cycle extended, and waiting for reflation keeps paying dividends.”

Van der Welle says the direction that earnings are about to take as markets head into 2020 is key, as late-cycle bull markets will hinge on earnings delivery.

“This is especially true for the current late-cycle market, since the space available for conventional monetary policy to prop up risky assets is rather limited from a historical perspective,” he says.

“Markets can only stay irrational, or without policy support, for so long. Analysts already expect S&P 500 earnings to trough in Q1 2020 and to improve as the year progresses. This could be on the optimistic side, as reflation and the bottoming out in earnings could take longer to unfold in 2020 than consensus expects – as it did back in 2016.”

“While we stick to our reflation base case for 2020, the early 2020 reflation hypothesis is being put to the test in our view. A couple of factors have somewhat reduced the odds of an early 2020 reflation. The further weakening of the November ISM manufacturing producer confidence index to 48.1 – a number released prior to US President Trump’s warnings about a potential postponement of the trade deal – shows that spillover risks to the services sector have not vanished either.”

Subsequently, the Robeco Global Macro multi-assets team has been taking some risk off the table. “We have reduced our equity exposure in recent weeks, as the upside for tactically taking equity risk has diminished in our view,” Van der Welle says. “This has left us with a marginally overweight position in global equities and an underweight in global high yield bonds.”