Don't be misled by better-than-expected earnings, JP Morgan says

Investors shouldn't be fooled by better-than-expected third quarter corporate earnings, much less given the increased scope for volatility in bond and foreign exchange markets, strategists at JP Morgan said.

Third quarter profits in both Europe and the US were likely to rise in the low-single digit range, but consensus projections for earnings per share in 2016 and 2017 would continue to fall, Mislav Matejka, Emmanuel Cau, Prabhav Bhadani and Aditi Balachandar at JP Morgan said in a research report sent to clients.

For the three months ending in September, currencies were likely to prove a tailwind for the UK, emerging markets and the US, while the drag from commodity price rises was ending.

Yet since the start of the year, analysts had cut their forecasts for the rate of growth in earnings in each of those regions from 10% year-on-year to -2.0% and -1.0%, respectively, they said.

Even so, current consensus forecasts calling for profits to rise by between 12% to 13% in 2017 were too high, given the economic outlook and profit margins were likely to keep decelerating.

From a sector standpoint, JP Morgan said the recent "strong" rally in cyclicals meant they were no longer cheap versus 'defensives', having moved to trade in-line with their historical price-to-earnings multiple relative to defensives.

The pace of EPS revisions for cyclicals also remained negative, prompting the broker to point out Energy as a sector offering a better risk/reward trade-off into the reporting season.

On the subject of the recent back-up in bond yields, JP Morgan said past relationships pointed to equities coming under pressure should volatility in bonds resurface.

Intriguingly, stocks would not be the beneficiaries of any reversal in inflows into bond funds, the broker said.

Neither had the recent jump in UK Gilt yields been "for the right reasons", given heightened volatility in the FX space, they believed.

"We remain overweight the FTSE 100 (currency hedged) but believe this situation has the potential to escalate."

Banks and insurers had not decoupled from bond yields and remained the attractive hedges againgst another rise in yields - particularly insurance, as it did not suffer the handicap of banks' structural problems.

"We believe the recent sell-off in defensives is creating opportunities, with Utilities and pharma looking increasingly attractive."