In 2016, we could see upward revisions in earnings expectations as the year progresses. But while earnings may be improving, we believe equity markets hold limited upside potential

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The first quarter results season is almost over, and has been marked by positive surprises from Europe and, less so, the US, while Japanese earnings appear to have suffered from the strength of the yen. US and European net earnings came out 1.4% and 11.2% ahead of expectations, respectively, according to Bloomberg data. By contrast, Japanese earnings were the worst since 2013, with net profits 37.5% below expectations.

Every year since 2013, earnings expectations have been revised lower as the year progressed, and this trend accelerated after 2014, with energy and commodity sectors accounting for the bulk of negative revisions. This year could develop differently, as the trough in metals and oil prices and positive earnings revisions in the relevant sectors started only recently. Hence, according to Datastream figures, the recent earnings upgrades are lagging the 83% recovery in oil prices since January. The positive contribution to the overall earnings picture from the energy sector should therefore continue. This factor will improve the picture mostly for US and European earnings, but much less so in Japan, as the energy sector only represents 0.5% of the Topix index.

Recent equity market peaks coincided with the ECB and BoJ decisions to impose negative rates. From December 1st to last Friday, the MSCI World index declined by 14%. During the same period, the MSCI world banks index declined by 24%.

Recent chronology of events Since 2009 and up until recently, central bank action has helped to stabilise equity markets. Looking at recent events, it now seems that the opposite is becoming true. The last two monetary decisions (ECB on 3 December 2015 and BoJ on 29 January 2016) coincided with intermediary peaks in developed market indices. In the second case, the Bank of Japan’s decision interrupted the rebound that had been taking place since from 20 January. Thus, from their November 2015 top to last Friday, the declines on the S&P500, Stoxx600 and Topix amount to 12%, 17% and 25% respectively.  More disturbing still, the banking sectors were big negative contributors in this correction, with underperformances of 9% in the US, 11% in Europe and 18% in Japan. Moreover, those declines have pushed the valuation ratios of banking sectors to their lowest level since 2012, indicating the markets’ doubts about banks’ balance sheet stability in all three regions. Finally, CDS on bank subordinated debt have recently shown some signs of stress, indicating that the weakness in equity valuations is also reflected in credit markets.

The decline in equity markets since the start of the year stands out as one of the largest in history in January, not only in its magnitude but also its suddenness.

One has to go back to 1897 to find such a bad start for equity markets. This note will analyse the situation on the markets and the prospects for a rebound.
As often in a large correction, one can find many causes. We think the following are the most significant:
Monetary policy running out of steam.
The fall in commodities prices.
Concerns about China.
The strengthening US dollar.
The rise in corporate bonds yields, notably in the High-Yield market
Chinese circuit breakers, market liquidity and risk reduction With regard to the sell-off in China, an important point is that policy mis-steps exacerbated the draw-down. On 1 January the Chinese authorities implemented new circuit-breaker rules. Instead of limiting market volatility, they actually amplified it. Twice during the first week of January, investors rushed to sell and thus triggered the first circuit breaker at -5%. When markets reopened, new sell orders were added on top of the ones that had been unexecuted, thus triggering the daily market close at -7%. Those measures were abandoned after only one week.