The most important earnings season of the year

The crucial Q2 US earnings season starts next week. It is a key test both to the recent turn up in EPS expectations, with the earnings revisions ratio strongly recovering to borderline 50% level (chart below) and the market rally. But uncertainty is very high, with consensus forecasts for -43% yoy EPS fall, the crisis trough, versus the S&P 500 +6% rise in last 12 months.

A resilient earnings season is one of our four upside catalysts for the market, alongside the activity resilience to rising virus cases, a phase 4 fiscal stimulus plan, and Biden election tax increase/Senate “clean sweep” fears contained.

We highlight the nine things to track below. We continue to see US equities (SPY) as better supported than feared, and run a balanced portfolio of quality growth tech (XLK) and healthcare (XLV) and select cyclical recovery segments, such as small caps (IJR), consumer durables and real estate (VNQ). For background, see our notes: July 1, “Nasdaq Parallels With Tech-Bubble,” and June 26, “Value Down, But Not Out.”

US earnings revisions ratio

The context from Q1

Q1 US earnings were better than feared and helped support the market turnaround, but only included around one month of national lockdown. Whilst there was a huge sector earnings divergence, over 60% of the index saw EPS growth, with Energy the major upside surprise versus low expectations, and Financials the only big negative, as banks aggressively built loan loss reserves.

The nine key things to know going into this earnings season is:

1. Q2 set to be the real test, and the earnings trough

The second quarter will show the full impact of the national shutdown on US corporates. Consensus expectations are for an 11% revenue fall yoy and a 43% earnings decline. Consensus (see chart below) says this is the revenue and earnings growth trough, and is set to be an estimated three times worse than the -13% yoy Q1 EPS fall, and the biggest earnings decline since the Q4 2008 -69% earnings crash in the Global Financial Crisis.

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2. Companies to beat expectations, but uncertainty above average

Analysts have cut consensus expectations dramatically into the quarter. Q2 EPS is down 9pp the last eight weeks, much more than usual. Companies then historically report better-than-expected earnings. This “surprise” has averaged 3.3% long term, with c70% of US companies beating expectations. Though this time there is above-average recession uncertainty, given the “sudden stop” nature of the recession and the lack of corporate guidance.

Q2 US earnings

3. Huge earnings divergence continues

We expect to continue to see a huge EPS divergence between sectors. Five sectors are forecast to see earnings declining <20%, and these sectors comprise 55% of the S&P 500 (see chart below). By contrast, at the other extreme are four sectors, representing 32% of the index, forecast to see earnings fall >40%. This is a further reflection that the S&P 500 is not the economy, and is focused more on tech and large caps than the economy.

4. Discretionary and Industrials led downgrades

Discretionary sector Q2 earnings expectations have fallen over 80% since the start of the second quarter, led by Ford (F), General Motors (GM) and Amazon (AMZN). Industrials sector EPS expectations have fallen 55%, led by General Electric (GE) and Delta (DAL). Energy and Financials have also seen significant falls, continuing the decline leadership seen in Q1. By contrast, Tech and Utilities’ Q2 EPS expectations have been the most resilient of all US sectors, both down only c6% in the last three months.

5. Banks in spotlight after Q1

Financials were the biggest sector disappointment of Q1 earnings, as they aggressively increased loan loss provisions, and Q2 sector EPS has been cut c40% in the last three months. Sector stock price performance has also continued to lag. Whilst now only the fifth-largest US sector, with 10% index weight, a better Financials sector outlook would go a long way to sustaining the recent market rally. They also report first in earnings season and could set the tone for the season.

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Q2 Earnings

6. Margin compression and reopening costs

Overall S&P 500 net profit margins fell to 9.3% in Q1 from 11.3% yoy, led by Financials and Discretionary. The highest-margin sectors – Real Estate, Tech and Utilities – all showed relative resilience. Margins are likely to stay under pressure from lower fixed-cost dilution and operating leverage given the lower revenues, but also the potentially high reopening costs, with a recent PwC CFO survey showing these could be significant, and Amazon – to name but one company – guiding to US$4 billion of extra Q2 costs alone.

7. A better international performance

Domestic-focused companies saw more resilient revenues (+2.1% yoy) than those with majority international revenues (-2.9%) in Q1. We expect a better international performance in Q2, as China and European markets reopened earlier, with the US lockdown Stringency Index remaining above the global average. Additionally, a weaker USD was a tailwind in the quarter, after two years of strength, with the DXY USD index weakening 2.9% in Q2.

8. Restarting guidance or dividends

Companies may also restart earnings guidance or unsuspend dividends. Either would be a positive market indicator, reflecting lower uncertainty and/or greater business visibility. Approximately 185 of the S&P 500 have suspended earnings guidance this year, an unprecedented number, whilst we are just beginning to see some dividend pressures begin to ease. Twice as many S&P 500 companies have increased dividends in June as those that have cut or suspended them.

9. Validating the market bounce back

2020 consensus US earnings are forecast down 23%, whilst 2021 consensus is forecasting a 31% bounceback. This would leave full-year earnings next year (2021) in line with those of 2019. These expectations go a long way to supporting current valuations. S&P 500 is on 22x 2020 consensus P/E vs. the 5-year average of 16.7x and well above the 10-year average of 15.0x. This valuation falls to a full, but still more reasonable, 19.6x on 2021 earnings expectations, supported by bottoming earnings expectations, low bond yields, and still-cautious investor sentiment.

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US valuation

Reasons risks are above average, but they may not matter

Earnings risks are clearly above average this quarter for multiple reasons: 1) The severity of the earnings and GDP drawdown, being dramatically worse than Q1, with NY Fed Q2 “nowcast” at 15% GDP growth. 2) The lack of company earnings guidance, as discussed above. 3) The above-average valuation of the market, and hence, traditional sensitivity to a significant earnings miss.

An alternative view could be that earnings matter less now than they have done historically, given the unprecedented US monetary and fiscal support, with the Fed balance sheet expanding to US$7 billion, unlimited quantitative easing (QE) and policy rates at zero all combining to support much higher than historic valuation levels.

Conclusion: Most important earnings of the year

Second-quarter US earnings start next week and are crucial to supporting the market rally and upturn in earnings expectations. We expect companies to beat expectations, with huge sector divergence as defensives and quality growth outperform deep cyclicals. Banks will be in spotlight as first to report and the major Q1 disappointment. Focus will also be on margins (reopening costs), international (loosened first) and guidance/dividends (improving). As we mentioned earlier, we continue to see US equities as better supported than feared, and run a balanced portfolio of quality growth tech and healthcare and select cyclical recovery segments, such as small caps, consumer durables and real estate.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.