In spite of second-quarter and first-half earnings being horrific, equity markets have rallied, as earnings surprises, at least in the US, have been extraordinarily positive. Europe did not do as well: surprises have been largely negative. This helps explain the market’s underperformance.
While there is room for earnings forecasts to be adjusted upwards, the main risks are the re-imposition of strict, nationwide lockdowns and high US tech valuations. On the first, governments appear reluctant to take such economically damaging measures again. On the second, tech multiples can stay high for longer in a world of low growth and low interest rates.
A disaster foretold
The consequences for corporate profits of the lockdowns are becoming apparent as second quarter/first half earnings roll in. After a 13% fall in profits in the first quarter for the US, and -30% in Europe, this quarter was expected to show declines of more than 40%.
While results have been bad across the board, energy, airlines and financials accounted for two-thirds of the losses at S&P 500 companies, even though they make up just 14% of the market capitalisation.
The figures have come in alongside rising markets, however, because earnings surprises have been exceptionally large and positive, at least in the US. That should not be startling given the general lack of earnings guidance from companies and the pervasive uncertainty around the course of the pandemic and the response of governments.
Beating expectations – the US leads Europe
US company earnings beat analyst expectations by 20%. Importantly, the surprises have been spread across sectors except for energy. Although headlines have highlighted the blowout results for tech stocks, the broad tech sector accounted for just a quarter of the surprises for the whole index.
Results in Europe were less encouraging. This helps explain why the index underperformed by 7% this month despite the region’s better management of the pandemic. Lockdowns were imposed earlier, lasted longer, and were more restrictive in Europe. The impact on GDP was commensurately larger: the US economy shrank by 9% in the second quarter, the forecast for the EU is -15%.
However, this difference should already have been reflected in earnings estimates. For the MSCI Europe index, surprises are -3%. Excluding energy, surprises are -8%. For those sectors that have had positive surprises, several have averaged just 1.7% compared to 50% for the US S&P 500.
All is not negative, however. Several industries have managed to grow year-on-year earnings significantly, particular technology, healthcare, and (home) entertainment (see Table 1).
Table 1: Top sectors for year-on-year earnings growth
Data as at 5 August 2020. Source: Bloomberg, BNP Paribas Asset Management
Supporting the market – positive guidance and upward revisions
Companies that have continued to guide on future results were inevitably ones with a positive story to tell. Just 220 companies provided an outlook, down from nearly 500 at the same point last year. Their guidance was exceedingly positive, with nearly 60% of companies raising guidance.
Earnings revisions have also supported the market, though more so in the US. Upward revisions in the US are nearly twice downward revisions and the ratio has been improving for the last several months. In Europe, the trend is positive, but the ratio is only just now reaching parity.
Threats to further gains
Given the surge in infections in many other parts of the world, the key question is whether this momentum can be sustained. So far, renewed restrictions have generally been limited to bars and restaurants, which represent a small part of most economies. If more severe lockdowns become widespread, market optimism will likely fade quickly.
Bullish investors have focused on improvements in coronavirus treatments, even as most acknowledge a vaccine will not be available widely in the near term.
Analyst expectations suggest there is still room for earnings to rise (see Exhibit 1). The ability for further upside assumes a second wave does not lead to a double dip (recession), but the hurdle seems high for governments to re-impose economically costly nationwide lockdowns.
The other main threat to the market’s gains is tech sector valuations. The second-twelve-month forward price-earnings ratios for the US ex-technology market and for Europe are above average, but still below the highs over the last decade. However, for the broad tech sector, the measure is now at levels reminiscent of the tech bubble of the late 1990s (see Exhibit 2).
Earnings estimates are likely to rise as they incorporate the latest earnings surprises. This should lower the multiple. Moreover, the long-term growth rate estimate for broad tech has risen by nearly 100bp this year, while it has fallen by 60 bp for the rest of the US market and by 200bp for Europe.
What might spark a correction?
Ahead of the US presidential election, anti-China and anti-trade rhetoric by president Trump will likely continue and tech might underperform the rest of the market. A Democratic sweep would increase the odds of higher taxes and regulation for the sector.
That said, the peak in the tech bubble in 2000 did not arrive for 15 months after multiples were at the same level as they are today.