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Can earnings keep pace with the stock market rally?

Record earnings for FTSE 100 and 'mid-cap' companies in the last three months of 2016 bode well, but are they enough?

 
Can earnings keep pace with the stock market rally?

Revenues for FTSE 100 and 'mid-cap' companies hit a record high in the last three months of 2016, but will this be enough to sustain a seemingly eye-watering valuation on the UK stock market?

Online stockbroker The Share Centre has highlighted a 5.5% jump in revenues to £116 billion from companies reporting full-year results at the end of last year, a record result for this cohort of stocks.

That will go some way towards justifying what at first glance looks like an outlandish 26 times price earnings (PE) ratio on the FTSE 100, although down from as high as 33 times at the end of December.

But it's worth bearing in mind this is a historical measure, based on past earnings that do not yet fully reflect the pound's heavy fall following the Brexit vote, which will provide a substantial boost to companies' overseas earnings.

FTSE 100 companies make around three-quarters of their earnings overseas, while revenues are split roughly 50-50 between the UK economy and overseas markets in the FTSE 250.

Nor will these historic earning figures fully capture the recovery in the commodities markets, with oil and metal prices rallying from lows, helping the FTSE 100's sizeable contingent of oil giants and miners.

That's reflected in the fact that the FTSE 100's forward PE ratio, based on investors' expectations of earnings this year, is a much more palatable 15 times, in line with its historical average.

Bridging the gap

So will actual earnings make up that gap? The first signs are encouraging, with full-year earnings reported in the last three months of last year, typically covering the 12 months to the end of September, the first to reflect the pound's 15% fall against the dollar following the EU referendum.

The Share Centre said that sharp fall had played a big part in the record earnings result. 'Contract caterer Compass (CPG) is the largest by sales to report in the quarter. With much of its business in North America, the soaring US dollar boosted an already strong performance for the group,' it said.

'The same pattern repeated at Wolseley (WOS), the plumbing and building materials distributor, and at airport and railway station food group SSP (SSPG).'

There was a note of caution from pre-tax profits, which take into account how much a company is borrowing to finance itself. These fell 2.6% on the previous year.

However, this was largely down to just three companies – tobacco company Imperial Brands (IMB), property developer Shaftesbury (SHB) and budget airline Easyjet (EZJ) – and masked good performance elsewhere.

'A weaker pound is supporting internationally exposed large-caps, and those with overseas, or dollar-based earnings will see dramatic rises in sales and profits in the year ahead,' said Helal Miah, investment research analyst at The Share Centre.

'These will also benefit from an improving outlook for global economic growth. With steadily rising oil and commodity prices, and as the giant pharmaceuticals see more reward from research and development investments, we expect the top 100's largest sectors to perform well this year.'

Against that backdrop, Miah saw the rating on UK shares as fair. ‘Compared to the average over 20 years, I don’t think they’re overvalued,' he said.

Strong momentum

Russ Mould, investment director at AJ Bell, the fund supermarket, pointed to the momentum behind some of the largest sectors in the FTSE 100.

‘The FTSE 100 is very sensitive to four sectors; oil, mining, banks and insurers. In terms of earnings… in 2017 they are predicted to make up three quarters of earning growth,’ he said.

‘The oil price is up, metals prices are up, and insurers and banks have been helped by the yield curve steepening, which is improving their net interest margin. Banks have taken out lots of cost as well.’

He said if the dollar continued to go ‘the right way’ and oil prices maintained their rally then P/E ratios would still be justified. However, Mould added that while ‘the quantity of earnings is improving, the quality is not as high’.

Earnings could still be at the mercy of ‘the swing factor’ of sterling movements.

‘If the Bank of England starts to move up interest rates at all…and sterling goes up…then earnings growth is not going to be as good,’ said Mould.

The key problem that investors could face is that US president Donald Trump fails to fulfil the promises he has made to boost the US economy through tax cuts and increased infrastructure spending.

‘We have had a strong run-up in the market since Brexit and that was boosted by Trump,’ said Mould. ‘I’m of the view that the market has most of this behind it and going forward there is not too much to go for. If Trump does not deliver [on his promises] then we could see a pull-back in the market.

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