- Despite being lower on a year-over-year basis, 3Q20 earnings have come in better than expected
- Consumer staples, technology, health care, and utilities are expected to see positive earnings growth on a year-over-year basis; the remaining sectors are expected to post double-digit declines
- Individual names have not responded to better than expected earnings reports, suggesting a lot of this good news was already priced in
- Expectations for 2021 profits may be too robust and will need to come down in the coming months
Profits getting better, guidance coming back
Following a sharp decline in activity during the first half of the year, the U.S. economy grew at an annualized rate of 33.1% in the third quarter. This is the best quarterly growth rate on record, but there has been significant divergence beneath the surface; the realization of pent-up demand for consumer goods and better manufacturing activity have been the primary drivers of growth, whereas services remain under pressure.
Against this backdrop, profits have rebounded nicely, with 3Q20 S&P 500 earnings per share (EPS) growth positive on a quarter-over-quarter basis. While earnings are still down 11.3% from a year prior, it is important to look at this relative to the -49% y/y decline in the first quarter and -33% y/y decline in the second. Furthermore, results have been better than expected; with 71.8% of companies reporting, our current estimate for 3Q20 S&P 500 operating earnings per share is $35.31. So far, 87% of companies have beaten earnings estimates and 77% of companies have beaten revenue estimates, both of which are well above long-run averages.
Analysts set the bar too low coming into the 3Q20 earnings season, as evidenced by the fact that those sectors most impacted by the pandemic – consumer discretionary, energy, industrials, materials, and financials – are seeing earnings surprise significantly to the upside, despite being lower than a year ago. At the same time, earnings growth has been both positive and better than expected across the technology, health care, consumer staples, and utility sectors (EXHIBIT 1).
EXHIBIT 1: Earnings results have been much better than expected
Earnings surprise (%) by S&P 500 sector
Companies are also beginning to provide guidance after suspending it in early 2020. This suggests that managements are more confident in the outlook, but it is important for investors to recognize that the return of guidance has coincided with better-than-expected earnings. We believe that 2021 earnings may not bounce as strongly as many believe, and if this is indeed the case, consensus estimates for earnings growth of 42% next year will need to decline in the coming months.
Still dealing with the COVID divide
Although the economy is coming back online, the road to recovery will be challenging. From a profit standpoint, only four of the eleven GICS sectors – consumer staples, technology, health care, and utilities – are expected to see positive earnings growth on a year-over-year basis. The others are generally expected to post double-digit declines.
Financial services companies have kicked things off, and although profits are expected to decline on a year-over-year basis, more than 75% of companies have beaten earnings estimates and surprises are currently tracking 23%. Bank profits in particular have been better than expected, as strong trading revenues and lower than expected loan loss provisions, which currently stand at 8.3% of sales relative to 19.7% of sales in the aftermath of the Global Financial Crisis (GFC), have boosted the bottom line (EXHIBIT 2). At the same time, asset management firms have seen profits boosted by rising assets under management (AUM) and higher fee revenue.
EXHIBIT 2: Loan loss provisions have been more modest than after the GFC
Loan loss provisions % revenue, S&P 500 financial sector
Staying with the more cyclical parts of the economy, energy company profits remain under significant pressure due to a combination of lower oil prices and a collapse in demand. Although the average price of a barrel of WTI oil was down -27.5% from a year prior, upstream company profits have generally been better than expected as companies have cut back on investment spending and focused on expense management.
At the same time, companies in the materials sector continue to struggle. However, results have beaten estimates, as chemical companies in particular have demonstrated an ability to increase prices despite softer demand. This has manifest itself in margin expansion, which should be a further tailwind for profits as economic activity continues coming back online. We have also seen widespread weakness in the industrial sector, particularly in airlines and aerospace/defense.
Earnings at consumer discretionary companies are expected to be soft, as gaming, lodging, and leisure struggle in a world of social distancing. That said, hardline retail numbers have been better than expected, which aligns with the economic narrative around solid housing activity and the consumption of goods. Internet retail looks to have received a boost from traditional e-commerce names but is seeing some drag from travel-related services. Turning to the restaurant industry, results have generally beaten estimates as the number of seated diners in the U.S. continues to recover from its March/April lows (EXHIBIT 3).
EXHIBIT 3: People are going out to dinner, but not like before the pandemic
Year-over-year change in the number of U.S. seated diners
The areas of the market expected to see positive earnings growth have continued to benefit from many of the trends that took hold earlier this year. Health care earnings are beating expectations due to robust activity in biotech/pharmaceuticals, whereas providers and equipment are dragging on results. In the technology sector, profits are expected to be primarily driven by software and semiconductor companies, which ties directly to the story around the greater use of cloud computing, software as a service (SaaS), and stronger chip demand. That said, technology services, payment processors, and hardware are all expected to see earnings decline. Finally, some consumer staples companies have continued to benefit from strong demand for health and hygiene products, while those who rely on in-person events to sell their products have enjoyed less success.
Balance sheets and the outlook for earnings
Usually, when a company reports better than expected earnings, its shares enjoy a brief period of outperformance. However, the lackluster price response to earnings beats this quarter has eroded a well-known alpha opportunity that is usually available during earnings season. As such, it is reasonable to assume that these better-than-expected results were very much priced in. Looking at performance following earnings announcements, the average stock in the S&P 500 has fallen 0.1% during the following trading session after beating on earnings and revenues, while the average stock that beat on earnings and missed on revenues fell -0.4%. This contrasts sharply with those names that have missed on both earnings and revenues, as well as those names that missed on earnings but beat on revenues; under both of those scenarios, the average stock fell nearly 4%.
So, with 2020 earnings generally better than expected, but much of this priced in, where do we go from here? To start, if we apply an average earnings surprise of 6% to next quarter’s earnings estimate, 4Q20 S&P 500 operating EPS would only be down -2.7% from a year prior. While the annual value of earnings this year would still be down 24% relative to 2019, this does suggest that the bounce in earnings that many are expecting in 2021 may be difficult to achieve. Standard & Poor’s is currently forecasting earnings growth of 42% in 2021 ($164 per share), which feels too aggressive given what has been observed year to date.
But if earnings do not come through as expected, what does this mean for the health of the corporate sector? Luckily capital market activity has been robust this year, as companies have taken advantage of low rates and strong investor demand to issue both debt and equity. The question, however, is how these funds are being used. EXHIBIT 4 looks at the ratio of gross and net debt for S&P 500 companies; the ratio has increased this year, suggesting that companies are saving this cash, rather than paying it out to shareholders or reinvesting in their business. Against this backdrop, a softer than expected bounce in earnings next year would not be as problematic, as companies have reinforced their balance sheets after staring into the abyss back in March.
EXHIBIT 4: Capital markets activity has led to an increase in corporate cash
Ratio of gross to net debt, S&P 500 companies
There is always uncertainty about what lies ahead, although the current environment feels more uncertain than usual. What will the election outcome look like? When will the virus be brought under control? Will the economic recovery remain on track next year? How will U.S./China relations evolve going forward?
As investors weigh these issues, the best approach to equity markets seems to be one of balance. Value looks cheap relative to growth and will outperform as economic activity accelerates and inflation expectations rise next year; the challenge, however, is knowing exactly when this will occur. At the same time, we like growth from a structural standpoint, and want to maintain exposure to many of the long-term trends that are prevalent across technology, health care and communication services. Going forward, we would encourage investors to ensure they have sufficient value exposure in portfolios, while simultaneously trying to increase active share when allocating to growth.
On the issue of small versus large, we advocate taking a balanced approach as well – small caps should outperform as the economy comes back online, whereas large caps will outperform during periods of uncertainty. With limited valuation signals, and plenty of questions around the near-term trajectory of the economy and corporate profits, deviating from long-run, strategic allocations seem ill advised at the current juncture.