How to interpret Q3 earnings

Q3 earnings season in the United States could provide some information on how far along in the global healing process we really are.

Our Top Market Takeaways for October 16, 2020.

Market update

The eye of the beholder

You can tell any story you want about the price action this week.

The negative version: The rally in U.S. stocks sputtered this week as stimulus prospects before the election all but fizzled. The S&P 500 flatlined as Treasury Secretary Mnuchin and House Speaker Pelosi have seemingly failed to compromise on a much needed fiscal support package that is targeted at providing supplemental unemployment insurance, stimulus checks, and support for state and local governments. The failure to reach a compromise could be the first step down a path of austerity that could be negative for markets and the economy over the medium term. The unemployment insurance data released Thursday underscored the need for further support. Almost 900,000 Americans filed initial jobless claims, the highest since August. Through Thursday, bank stocks slipped -1.0% even after reporting relatively decent earnings results, and European stocks lost -2.0% amid a worsening COVID-19 second wave.  

The positive version: Despite more “deal or no deal” drama in D.C., stocks were surprisingly resilient through Thursday’s close. The tech (+1.1%), communication services (+0.9%) and consumer discretionary (+0.8%) sectors all gained. Apple (which designs the phone) and Qualcomm (which makes the components) gained over +3.0% as investors sized up the potential of the new 5G capable iPhones. Onshore Chinese stocks gained +2.5% after the Golden Week holiday spurred travel and consumption. Treasury yields and high yield credit spreads barely budged.

See? The tone matters.

The day-to-day information flow will continue to move markets, but its fervent pace will (hopefully) peak on election day. But until then, it will be important not to overreact to short-term information. We are more focused on the durable healing process that is underway globally, the continued support that policymakers are likely to provide for that healing process, and consistent medical progress with respect to the virus.

Third-quarter earnings season in the United States could provide some information on how far along in that global healing process we really are. 

3Q U.S. earnings preview: Better, but still bad

When we were gearing up for the second-quarter earnings season, we told investors to brace for “peak pain.” The second quarter ended up not being quite as bad as everyone was expecting, but was still pretty awful (consensus estimates were calling for a ~45% decline in earnings; they ended up falling -31%). Regardless, we still think the second quarter represented the worst of the COVID-19 crisis for corporations. 

As for the third quarter earnings season, which kicked off this week, expect it to be better—but still bad.

Consensus estimates are currently calling for headline S&P 500 3Q earnings to drop -21% versus last year, with earnings in every sector expected to contract. 

Pandemic-related headwinds persisted throughout the third quarter, and the effects are apparent at a sector level. Energy has been hit the hardest by far as oil and gas companies continue to deal with depressed demand and low oil prices that make it tough to turn a profit (or break even, for that matter). Industrials are getting dragged down by the airlines industry. Hotels, restaurants and leisure are the biggest pain point for the consumer discretionary sector. Meanwhile, defensive sectors such as healthcare, consumer staples and utilities are expected to hold up relatively well.  

Is there anything to be optimistic about?

Our Equity Strategy team thinks technology, healthcare and consumer staples could end up seeing positive growth in 3Q, despite consensus expectations to the contrary. In fact, we think there’s strong potential that reported results in aggregate come in better than consensus expectations. During 3Q, we saw the second most positive EPS revisions in over 10 years—consensus estimates improved 4%, compared to average intra-quarter revisions of -5.7%. The only other quarter with stronger positive revisions was 1Q18, and S&P 500 earnings ended up coming in 7% higher than consensus originally expected (growing +25% year-over-year versus estimates of +18%). 

Chalk it up to the better-than-expected pace of economic recovery—Citi’s Economic Surprise Index jumped to and stayed at its highest levels in decades throughout the third quarter, and the earnings expectations followed. 

Any other bright spots?

Yes! Mega cap tech (…are you surprised?). Taken together, expectations are calling for Facebook, Amazon, Apple, Microsoft and Google to grow sales by +13% and earnings per share by +1% year-over-year. Especially compared to the declines in sales and earnings per share expected for the broad S&P 500, the conclusion here is clear: Growth has been scarce, and scarcity commands a premium. The FAAMG stocks have deserved their year-to-date outperformance and high valuations.

Where do we go from here?

When it’s all said and done, full-year 2020 earnings for the S&P 500 will likely contract by -17% versus 2019 (EPS of $135 versus $163 in 2019). As you could probably guess, this means that we have valuation expansion and dividends to thank for the S&P 500’s ~10% total return so far year-to-date.

Going forward, we expect earnings to do more of the heavy lifting. As the economic recovery continues, we’re looking for earnings to grow ~26% to reach $170 per share for full-year 2021. While we’re still excited by the secular growth trends evident in sectors such as technology and pockets of healthcare and consumer discretionary for longer-term investors, the industrials sector is our favorite way to play the potential for a cyclical rebound as growth broadens out. Industrials valuations remain attractive, and the likelihood of more fiscal spending after the election bodes well for subsegments such as transport, construction, infrastructure and defense.

All market and economic data as of October 2020 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.


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