- Equity markets have rebounded quickly from their March lows on the back of the unprecedented fiscal and monetary policy response
- 2Q20 should mark a low point for earnings; technology and healthcare are holding up relatively well compared to the more cyclical parts of the equity market
- Corporate guidance should gradually return, which could help investors set realistic expectations for 2H20 and 2021
- Higher taxes are more a question of when than if; an increase in corporate taxes next year would weigh on the expected rebound in profits
- We are inclined to embrace more cyclicality in portfolios, but remain balanced in our views on growth vs. value
The equity market’s round trip
The second quarter saw one of the fastest stock market rebounds in history. In response, many investors are voicing concerns that markets have decoupled from the economy and valuations are now too high. Both of these things are true, but in the post-GFC era, we have often seen that the policy response matters more than the fundamentals in the short-run. Yes, in the long-run earnings will need to catch-up or prices will need to move lower, but in the interim, an aggressive and coordinated policy response has supported risk assets.
As a result, investors have chosen to look through 2020 and focus on the potential for a rebound in economic activity and corporate profits in 2021 (Exhibit 1). This is not wrong, as the virus and recession will both prove to be transitory, but there are many questions about the pace and shape of the economic recovery. With that in mind, investors will increasingly focus their attention on corporate guidance during the coming quarters – no matter how small or seemingly insignificant – to try and determine the trajectory of earnings in the back half of 2020 and into 2021.
EXHIBIT 1: S&P 500 earnings per share (EPS)
Index annual operating earnings
The second quarter should mark a low point for earnings, as margins collapsed and revenues came under significant pressure. With that in mind, and 122 companies reporting earnings (28.5% of market cap), our current estimate for 2Q20 S&P 500 operating earnings per share is 22.29 USD, a -44.5% decline from a year prior. However, we have seen a 5-year high 80% of companies beat earnings estimates and 66% of companies beating revenue estimates, suggesting that the bar for 2Q profits may have been set too low by analysts. Earnings look set to contract on a year-over-year basis through the end of 2020, and while 2021 will bring its own set of issues, the bigger question is whether policy will remain supportive until corporate profitability comes back online.
Ugly across the board
Expectations coming into the 2Q earnings season were low and results thus far have been mixed. As usual, the financial sector kicked things off; generally speaking, bank earnings are under significant pressure due to the aggressive building of loan loss provisions and lower interest rates. That said, larger banks with diversified revenue streams are faring better than their regional counterparts, as elevated trading activity and healthy wealth management businesses have helped offset some of this weakness (Exhibit 2).
EXHIBIT 2: Source of revenues for diversified and regional banks
2Q20 reported sources of revenue
Earnings in the consumer staples sector have been a bit mixed. Businesses that are tied to live events, entertainment or eating out are all under pressure due to the continuation of social distancing, whereas businesses more oriented to consumption at home have fared well. Zooming out, headwinds from a stronger US dollar have been mentioned in a number of reports thus far, suggesting that US dollar weakness seen in May and June was insufficient in offsetting the strength seen in April.
The industrial sector sits at the epicenter of the downturn, as investment spending was put on hold and global economic activity ground to a halt in the second quarter. Specifically, airlines continue to struggle as flying demand has stalled, and railroad businesses have seen a sharp reduction in carload volumes. The energy sector remains under pressure, as the average price of a barrel of WTI oil is down 53.3% from a year prior against a demand backdrop that looks set to remain soft until the economy fully reopens. Earnings reports so far have cited decreased pumping activity, decline in drilling related services and charges due to asset impairments and inventory write-offs. Finally, the consumer discretionary sector looks set to exert a particularly large drag on earnings as social distancing continues, with weakness in autos, hotels, restaurants & leisure, as well as luxury goods all weighing on the headline figure.
However, not all parts of the equity market are being impacted by this downturn in the same way. Companies in the technology sector that have exposure to software and cloud computing have seen earnings and revenues hold up better than some of their more hardware-focused counterparts. Communication services companies focused on at home entertainment benefitted in 2Q20, but the outlook is lackluster as the boost in subscribers is likely to be a one-time event. On the other hand, those companies that derive a greater share of their revenue from in-person experiences and events remain under pressure. Finally, healthcare is one of two sectors that are expected to see positive operating earnings growth on a year-over-year basis, with results driven by a combination of pharmaceutical product mix and healthy consumer businesses.
Guidance, taxes, and margins
Back in March, investors were staring into the abyss. Companies pulled guidance, the Federal Reserve didn’t release economic forecasts and the Chinese government failed to identify a GDP target for the year. Since then, the Federal Reserve has released a new set of forecasts, we have another quarter of Chinese GDP data in hand, but we are still lacking any material guidance from corporate managements. The amount of uncertainty facing the economy makes corporations hesitant to provide guidance, and taking a step back, the number of companies providing quarterly guidance has actually declined over time. Some investors view this as a good thing, highlighting that it forces investors to take a longer-term view. At the same time, however, guidance can be helpful in understanding how twists and turns in the economy impact profitability, as seen in (Exhibit 3).
EXHIBIT 3: S&P 500 company guidance
3-month sum, seasonally adjusted
While predicting the course of the pandemic is clearly very difficult, some corporate guidance, or at least scenario analysis would be welcomed by investors. An assessment of the potential impact of higher taxes, for example, could be useful. Given the mammoth increase in the deficit, particularly this year due to the pandemic, higher taxes seem increasingly likely. That said, the increases could perhaps come earlier and ultimately be more moderate under a Democratic rather than Republican administration. In the event of a Democratic sweep, the corporate tax rate could increase to a top rate of 28% as proposed in campaign documents. We estimate this would bring the effective tax rate for S&P 500 companies from 17.6% up to 23.5% and, if implemented in 2021, would change our current forecast of 155 USD for 2021 earnings per share to about 140 USD per share.
A 2021 increase in corporate taxes would weigh on margins just as they are in the process of recovering. After peaking at 12.1% in 2018, margins declined to a level of 5.9% in the first quarter of this year, and we are currently tracking operating margins of 7.2% in the second quarter. Our models have margins gradually rising over the next 18 months to a level just north of 9%, but it seems unlikely that this would materialize if corporate tax rates were to increase next year (Exhibit 4). This would put the consensus view that profits will eclipse their 2019 peak by the end of 2021 at greater risk. That being said, it should be noted that a new, incoming administration, might well wait for a fuller economic and earnings recovery before raising taxes to try to tame the deficit. Furthermore, passing bills rarely if ever happens overnight.
EXHIBIT: S&P 500 sector tax rates
Back in 2015, one of our colleagues remarked that it “was not a market for heroes.” It feels like we are in a similar position today and making big directional bets in portfolios seems inappropriate. With a handful of growth stocks leading the broader index higher, many investors believe that this concentration is a risk. This may prove to be correct, but only if expected earnings fail to materialize.
In the interim, we continue to find a number of interesting opportunities across U.S. equity markets. With international economies handling the virus far better than the U.S., and the potential for further US dollar weakness going forward, we are inclined to take on a bit more value exposure in portfolios. A global reflation trade would support some of the sectors that have been hit the hardest over the past few months, and valuations are attractive; the industrial and financial sectors look particularly interesting.
At the end of the day, however, we recognize the structural tailwinds for sectors like technology and healthcare and want to be measured in how we embrace cyclicality. Demographic tailwinds will support spending on healthcare, and the role of technology in our lives will continue to increase. The key will be to focus on those companies that will able to generate sustainable earnings growth going forward, as those that cannot will be left in the lurch when policy supports eventually begin to fade.