Third-quarter earnings: overshadowed by uncertainty

With the third-quarter reporting season well underway, we’re seeing some welcome improvements in corporate earnings. But as the Covid-19 crisis continues, huge uncertainties persist, and this has muted investors’ response.

So far, third-quarter earnings are showing a marked improvement on a savage second quarter. Year-on-year contractions are now averaging around 13% in the U.S. and 30% in Western Europe – compared to 30% and 50%, respectively, in the second quarter.

Analysts’ expectations are being beaten, too. Unusually, analysts in developed markets had upgraded their earnings expectations before reporting season began. Even so, most companies have beaten those expectations by wide margins.

It looks as though around 85% of companies will beat consensus expectations. But there’s one big caveat: outlook and guidance from companies have been uncertain or absent altogether.

Investors craving clarity

This is the main reason that the stock market hasn’t reacted positively to earnings beats and has penalized missed expectations severely. Investors haven’t been looking in the rear-view mirror but want some clarity on what lies ahead. Companies have been unable to provide that.

Take the banking sector. In the first half, the focus was on provisions for delinquent loans. But even after those massive provisions, banks still don’t know where they stand. Jamie Dimon, J.P. Morgan's CEO, said that his bank could be overprovisioned by $10 billion or, in the worst-case scenario, underprovisioned by $20 billion. That colossal $30-billion swing shows just how uncertain things are.

At the macroeconomic level, the uncertainty has two distinct strands. The first has been the U.S. election and the potential implications for fiscal policy. Second, there are the questions over the path of the pandemic, the return of lockdown measures and the possibility of an effective vaccine.

Earnings announcements are raising important questions too. In the technology sector in particular, expectations of future growth appear to have overshot. Netflix missed expectations by a wide margin. The company had earlier warned that it was "pulling subscribers from the future" during lockdown, but its shares still fell sharply after its announcement. Despite beating earnings expectations, Facebook was also punished after it reported a decline in the number of its US users. Twitter beat earnings expectations but disappointed in user growth. Twitter's shares suffered a sell-off in response.

These disappointments offered a reminder that the growth such companies enjoyed in the first half of the year was boosted by accelerated take-up for their services when most people were confined to their homes. So investors shouldn’t expect that growth to be sustained at a similar rate in the quarters ahead.

Three of the largest tech companies – Apple, Amazon and Alphabet – all surpassed earnings-per-share forecasts. But in each case, investors have focused on what lies ahead. Alphabet has been rewarded for returning to sales growth, but Apple has been punished for weakness in iPhone sales. And Amazon’s eye-catching third-quarter earnings were outweighed by its lackluster fourth-quarter forecast.

Can the Covid winners keep going?

The key issue here is the sustainability of the Covid "winners" – the high-growth companies that prospered as the pandemic crushed their peers. What happens when and if activity normalizes? Will "value" stocks — such as industrials — play catch-up? And could that change the leadership of the market?

If an effective vaccine materializes and the U.S. political environment becomes more stable, banks and industrials could stand to benefit from both restored normality and increased fiscal stimulus. This could prompt a rotation away from tech stocks and towards cyclical areas of the market. We should be clear here that we don’t expect a sustained shift in leadership away from growth stocks (those supported by strong secular trends), but we do think that value stocks could stage a temporary snap-back under the right conditions.

And conditions for these companies appear to be improving. The results of the third-quarter reporting season point to a broadening of "beats" toward cyclical parts of the market – earnings of industrials, consumer and media stocks surpassed expectations, although they remain in deeply negative territory when compared with last year.

Asia leading the recovery

Another intriguing trend is the improvement in earnings at manufacturers of luxury goods, such as Kering, LVMH and Hermes. These companies did badly during lockdown. Now, however, they are receiving a boost from the recovering Asian consumer market. Asian countries have benefited from their "first in, first out" status during the pandemic, and the effective containment of Covid-19 in China, South Korea and Taiwan has allowed a semblance of normality to return there.

As the lack of corporate guidance indicates, it may be quite some time until we have clarity on the course of the pandemic and its economic effects. In the meantime, volatility and uncertainty are likely to persist. But as we look into 2021 the prospects for earnings recovery remain very real – especially in those areas where the Covid-19 pandemic has punched the biggest holes.

 

IMPORTANT INFORMATION

Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

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