David Lebovitz: Welcome to the Center for Investment Excellence, a production of JP Morgan Asset Management.

The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.

Today’s episode is on the first quarter earnings season and has been recorded for institutional and professional investors.

I’m David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence.

This past week we kicked off the first quarter earnings season. You know, earnings seasons come four times a year and they always tell us a lot about what’s going on in Corporate America and it gives good insight as to the health of large multinational corporations.

But what’s particularly interesting about this current earnings season is that it will give us the first good look at the impact of the spread of COVID-19 not only on the day-to-day activities with these businesses we engage in but furthermore how it can potentially be impacting the health of some of these corporations during months to come.

You know, the stock market has clearly been a bit uncomfortable with the outlook for corporate profiteer over the past couple of weeks given the levels of volatility we saw in margins. Essentially investors were just trying to figure out what the rapid spread of COVID-19 was going to mean for both the economy and corporate earnings.

In terms of what we know so far, you know, the banks have reported. You’ve seen a lot of them holding that capital to address any problematic loans that they may have on their books down the road but in terms of what management were saying we haven’t really heard a lot of changes to guidance. We haven’t really heard a whole lot of commentary. And I think the best frankly because there’s no good playbook for thinking about the current environment.

I mean, when recessions are caused by financial imbalances or a policy error at the Federal Reserve we have to have a framework for thinking about what the recovery might look like.

When an economy is put on hold because of the global spread of the virus, you know, we don’t really have a good framework for thinking about that. And to an extent I think what management and investors of this juncture are flying a little bit blind.

You know, when we think back to what these tractions and corporate profits have looked like historically and we do think that corporate profits are going to contract here for 2020 as a whole, data from (Robert Shore) shows that on average corporate profits declined by about 30% during an economic recession. After that adjusted corporate profits are supported by the BEA tend to contract closer to 20%. Clearly the contractions are far greater than what we see in GDP and that just highlights kind of the cyclicality of corporate profits relative to the broad economy.

And as we think about the contracting that we’re going to experience here over the remainder of the year, you know, we think it’s going to be somewhere to the tune of around 20%.

Now one of the things that’s giving us a little bit of pause is when we look at consensus estimates for earnings growth this year, consensus things that are only going to contract by about 10%.

And so clearly there’s some checking up to do when it comes to the analyst community.

And we have gotten again, as I mentioned, a glimpse at kind of the beginning of this earnings season kicking off with the bank here. Building loan loss provisions have been a key theme across all of the announcements so far.

Another thing though that’s coming through is that capital market activity has actually been better than expected which is a little bit surprising given all of the volatility that we saw into the end of the quarter.

That said, while banks have suspended buyback programs, you know, their dividends looked relatively safe. And when we think about the outlook for banks here, you know, we do not believe that they are facing the same risk as they were back in the runoff and the wake of the global financial crisis.

Thinking about some other sectors, when you think about the consumer sectors, mainly consumer discretionary and consumer staples, you think that consumer discretionary will be hit harder than consumer staples but the impact is not going to be uniform across the board.

With consumer discretionary obviously things like autos, hotels, restaurants, (unintelligible), traditional retailers, those should all see a negative impact from social distancing, whereas things like Internet retailers and other industries that have more oriented towards consumption at home should actually see some sort of benefit.

On the other hand, consumer staples, there seems to be a number of offsetting forces at work. We (unintelligible) some of these consumer discretionary companies because supply chains have been affected and economies have been shut down to try to slow the spread of this virus. But at the same time demand for things like household products has been nothing short of robust.

And so while both of these sectors will set to see earnings decline from the year prior the decline in consumer staples earnings will likely be far more contained.

Thinking about some sectors that actually might be positive earnings growth as they report their first quarter numbers, communication services and technology actually looked like they fared okay. Again significant difference of the industry level, when you look within communication services, those companies they’re the most leveraged in the digital economy. So think interactive media and services, certain type of entertainment companies, you know, these all will set to pose solid results, whereas on the other hand the businesses that rely on a more diversified product mix, so think about (unintelligible) perhaps also run the theme park they look like they came under some pressure.

On the technology front, again supply chain issues will front and center and what we’ve seen and heard from management thus far. But as increasing number of people are forced to work from home, you know, things like software companies have actually seen a bit of a tailwind for their revenue and earnings here over the past couple of weeks.

Finally I just want to touch on what’s going on in the energy, real estate, industrial and material sectors. All of these will set to really bear the grunt of the drawdown in earnings that’s resulting as a result of the spread in COVID-19. Energy in particular looks set to struggle during the coming months. Not only is the price of oil down about 16% for the year prior, it currently sits at a level where most producers are going to struggle to turn to profit.

So we take this dynamic and combine it with software demand and the aggressive use of leverage in recent years and it does look like from an asset performance standpoint the energy market is going to be under substantial pressure for the foreseeable future.

So the earnings outlook here clearly is not great but I think that there’s a devil in the details. And when we think about the different types of businesses out there and how they’re going to respond to the economy being shut down over the next few months I think that there’s a big difference between the capitalized more service-oriented businesses and the more capital-intensive manufacturing-oriented businesses.

In capitalized service business, your people are probably continuing to work albeit from home. You’ll probably see a reduced pace of scale but you’re not seeing scales go off a cliff the way that some of these other industries are.

And so you can see your business running in a way that a company has required these workers to be physically present (unintelligible) unable to use over the next few months.

And so fundamentally what we’re dealing with here in the economy is a cash flow issue, right? Consumers are getting their income. Businesses aren’t generating as much revenue. What we need to figure out how to do is bridge the gap between where we are today and the economy coming back online hopefully at some point later this year and those companies that can maintain some semblance of productivity and you can also more easily cut cost whether that’d be reducing headcount or reducing hours work they should arguably be in a better position to resume operating in a normal pace when the economy does come back online.

So we think that there are a lot of nuances to this. And as I mentioned earlier, we don’t have a good playbook for thinking about this current pullback in the economy. That means that increasingly investment decisions are going to have to be made in real-time.

So what does this mean for portfolios? At the end of the day we continue to advocate for a focus on quality with a dash of cyclicality. To us this means embracing technically healthcare, technology, consumer staples, separate of solid profit margins and low levels of leverage and taking advantage of underweight into more highly leveraged sectors like energy and REITs to maintain benchmark exposure to things like financials, again focusing on a combination of quality and cyclicality.

And by not running from one side of the boat or the other, this should allow portfolios to weather the storm in the short to medium term while simultaneously maintaining enough cyclicality to participate when markets do rally.

Thank you for joining us today on JP Morgan Center for Investment Excellence. CFA Institute members are encouraged to self-document their continuing professional development using their online CE tracker.

If you find our insights useful, you can find more episodes wherever you look in the podcast and on our Web site.

Recorded on April 15th 2020.

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