What comes after the earnings crash?

Corporations these days are in the process of reporting their business results for the second quarter. In light of the coronavirus lockdowns, analysts expect to see the steepest plunge in corporate earnings since the financial crisis. However, the degree of forecasting uncertainty is far higher than usual, so upside surprises cannot be ruled out. Expectations for the second half of this year, in contrast, are quite ambitious. If they end up not being met, the elevated valuations would make the equity markets vulnerable to corrections.

The coronavirus crisis has left scars

The second-quarter reporting season gained momentum last week with the release of numbers by the big US banks JP Morgan, Goldman Sachs and Citigroup. The majority of companies in the USA and Europe will disclose their financial figures over the next three weeks, and the data presented to investors look destined to be deep in the red. Analysts expect to see the weakest earnings growth since the financial crisis. An aggregate profit contraction by 40% is projected for the companies in the USA’s S&P 500 index, for example, and an aggregate earnings nosedive by almost 60% is forecast for the companies in Europe’s Stoxx 600 index. But just how poor of shape earnings are really in remains to be seen because the second quarter registered not only a record downturn in economic indicator readings, but also an equally striking rebound. This means that forecasting accuracy is subject to greater uncertainty than ever, in large part also because many companies have been keeping their cards close to their vests lately and have completely scrapped earnings guidance for this year.

Too much coronavirus fog

Companies scrap guidance

Percentage of companies in S&P 500 index that have withdrawn their earnings guidance

Sources: Bloomberg, Kaiser Partner Privatbank

Leeway for upside surprises

Despite the extraordinary circumstances, a pattern looks set to repeat itself once more during the current reporting period. In recent years it has become standard for equity analysts to constantly cut their profit estimates during the weeks preceding earnings disclosures and for companies to then regularly beat the lowered bar when they release their financial figures. So, it is not so unusual at all that more than two-thirds of US companies regularly surprise on the upside, and this time is unlikely to be different. Earnings estimates in recent weeks have been revised downward just as quickly as the coronavirus recession took us by surprise. In early April, the consensus estimate was still projecting aggregate earnings growth of +13% in the USA for the second quarter!

So, there is leeway for upside surprises this time as well, particularly in the wake of the sharp recovery in various economic indicators in May and June. The global purchasing managers’ index, for instance, jumped from an all-time low of 26.2 points in April to a reading of 47.7 in June. Retail sales figures have also recently come in just as strong, far exceeding macroeconomists estimates. The discrepancy between the (overly) low macro projections and the actual reported data has seldom been wider.

Macroeconomists were overly pessimistic
Will the same play out for corporate earnings?

Economic surprise indices 

Sources: Bloomberg, Kaiser Partner Privatbank

A breather for cyclical stocks?

Analysts’ Q2 estimates are especially low for cyclical sectors, whose earnings and revenue figures fluctuate more pronouncedly in line with ups and down in economic activity. After rallying briefly in May, cyclical-sector stocks, which often are also categorized as value stocks, recently started to significantly underperform again. Upside earnings surprises and another temporary phase of improved share-price performance could now unfold going forward for these stocks as well. To cite an example, the recent sharp price increase for some industrial metals like copper is beneficial for stocks in the materials and mining sector. Now that the price of oil appears to have found a floor, the energy sector, too, may be poised to surprise on the upside. The results reported by US banks reveal a significant increase in loan-loss provisions but, on the positive side, also show solid lending growth bolstered by various government support programs and reflect robust securities-trading revenue.

Dr. Copper seems confident
Cyclical industrial metal in uptrend

Copper price

Sources: Bloomberg, Kaiser Partner Privatbank

Formulating an outlook for the second half of this year isn’t easy

Once a reporting season is over, the next one is already on its way. When the current flood of data has receded, market participants are soon likely to turn their sights to the second half of this year. (Pinpoint) forecasts for economic growth and earnings are once again difficult to make here. It is evident, though, that the bars for beating profit expectations in the third and fourth quarters are still quite high. For companies in the USA, for example, quarter-on-quarter earnings are projected to climb 36% in Q3 and 15% in Q4. The earnings curve thus resembles a “V”, but that’s arguably only realistic if economic activity likewise follows a V-shaped trajectory. The likelihood of that happening, however, at least seems questionable because economic activity would have to increase almost by as much as it previously contracted, and there are no signs of that occurring at the moment. Under such an optimistic scenario, purchasing managers’ indices would soon have to rise sustainably toward the 52- to 54-point level, and that, too, is not in sight at present. This means that the very bullish corporate earnings forecasts thus far for the second half of 2020 look set to (have to) be revised downward soon.

The risk of a second coronavirus infection wave in Europe remains acute, and the USA hasn’t even reached the peak of the first wave yet. Another pandemic-driven back-and-forth between restrictions and easing could continue to dim business and consumer sentiment in the second half of this year. It is likewise questionable how long further government aid programs can keep the consumer spending engine running, particularly in the USA. Without further support measures, the huge spike in unemployment is bound to depress sentiment and at least slow the coming recovery.

The spike in unemployment…
…argues against a V-shaped recovery

Unemployment rate

Sources: Bloomberg, Kaiser Partner Privatbank

No change in favorites (yet)

Even though the second-half outlook for companies looks rather mediocre, there are at least likely to be some relative winners (and losers). Shares of defensive companies like those in the healthcare sector, which operate more or less independently of economic cycles, should continue to rank among the relative winners. Although these stocks have already performed very well to date, they possess further upside potential on the back of above-average earnings growth. Moreover, given the record-low long-term market interest rates, their valuations aren’t overstretched. The same goes for the IT giants in the USA and China. They have shown certain signs of overheating in recent days, pointing to a near-term consolidation, but the IT sector should continue to figure among the winners over the longer term.