As Q2 earnings season is about to begin, it would be useful to assess the level of expectations going into reporting season, and the risks ahead. According to FactSet, forward 12-month EPS estimates have been bottoming and begun to turn up after a massive downdraft.
On the surface, this appears to be a constructive backdrop going into earnings season. While I would normally agree, the current environment is anything but “normal”, and there are plenty of risks ahead.
Indeed, a summary of this week’s view from The Transcript, which monitors and summarizes earnings calls, reveals a feeling of cautious optimism based mainly from a top-down perspective.
- Economies around the world are reopening even as cases increase (IMF)
- People seem willing to accept higher infection rates (BlackRock)
- Even travel may rebound faster than people expect (TravelZoo)
- But there are still 20m unemployed and many won’t go back to work (Palo Alto Networks)
- A vaccine would be a game-changer (Bain Capital, IMF)
However, The Transcript from the previous week was far more cautious, though the perspective was more bottom-up.
- Demand continues to bounce back (GM, McDonald’s, Federal Reserve, Union Pacific)
- But uncertainty about the future is still very high (Federal Reserve, IMF)
- A huge number of people are still unemployed (The Kroger)
- Travel restrictions will probably remain in place for a while (Anthony Fauci, US National Institute of Allergy and Infectious Diseases)
- And there are signs that a second wave may be building (McDonald’s, Food and Drug Administration Former Ex-Commissioner Dr. Scott Gottlieb)
In other words, nobody knows anything, and the level of uncertainty is very high. FactSet reported that the level of corporate guidance going into earnings season has plummeted. Even though forward 12-month EPS estimates are rising, the confidence level of the estimates is low. Wall Street is flying blind.
The risks ahead
The main risks surrounding Q2 earning season are the difficulties and extra costs of reopening, the expected level of reopening, and rising liquidity risks due to low capacity utilization.
Tracktherecovery.org reported that the spending recovery has continued, but low-income household spending has recovered faster than high-income households. That’s not surprising, because low-income workers have a higher propensity to spend their stimulus payments. This begs the question of whether there will be another round of fiscal stimulus when the CARES Act payments ends at the end of July. The Senate is not expected to take up the question until mid-July. Both the Democrats and Republicans have their own political agenda in crafting stimulus plans. With the election only four months away, the risk is both sides of the aisle cannot come to an agreement and the economy goes over a cliff.
A real-time snapshot shows that small business revenue recovery has flattened out. Anyone expecting a V-shaped recovery is likely to be disappointed.
The US COVID-19 case counts are climbing again. While other developed economies have bent their curves, the unfortunate fact is US conditions are on par with EM countries like Brazil, India, and Iran.
The S&P 500 is at a technical crossroad as it tests its 200-day moving average and backtests its broken trend line. The VIX term structure is not signaling extreme fear. I interpret these conditions as that the market is cautious, but no panic. It may not fully discounting the risks and possible bad news from Q2 earnings season.
The WSJ observed that the market has already assigned a risk premium to companies that withdrew guidance, but will that be enough?
Many companies that have pulled their guidance represent the industries most affected by the coronavirus pandemic and most damaged in the stock market. On average, shares for the companies that have withdrawn or withheld guidance are down 18.2% year to date. By comparison, the S&P 500 is down 6.9%.
Investors need to be prepared for the risks of a change in the market narrative in the weeks ahead.