The impact of the Covid-19
crisis on US corporate earnings
The impact of the Covid-19 crisis on US corporate earnings has been significant. Given the lag or even absence of bottom-up earnings estimates, top-down quantitative models are being used to link earnings growth to the current economic and financial context. Given the uncertainty around the path for growth, alternative economic scenarios are worthwhile considering.
We have all seen how the coronavirus outbreak and containment measures, such as retail closures and social distancing, are having extraordinary repercussions in financial markets and economies. Economic activity collapsed in the first quarter, but with many more countries entering lockdown during April and May, the second quarter will be the worst quarter for global growth in 2020.
In the past, shares in companies that have withheld guidance have underperformed the wider market
At this point, we do not know how, or when, normal life will resume in full. Until there is widespread availability of a vaccine for the virus, any lifting of social distancing measures could risk a second wave of infections and the re-introduction of lockdowns. We have seen this in China, with some cities having to return to lockdown to control new outbreaks of infection. In this highly uncertain environment, companies initially found it very difficult to quantify the impact of this crisis and for the first-quarter US earnings season many withdrew forward guidance for revenues and profits. This makes it challenging for investors to assess the outlook for corporate profits, one of the key aspects in our investment decision-making process.
The messages from the earnings season
While the first-quarter earnings season gave us some insight into the initial effect of the virus, we are mindful that much of the information is backward-looking and uncertainty about the economic outlook remains elevated. It has not helped that many companies have refused to provide forward guidance. Under normal circumstances, only about half of the companies in the S&P 500 Index tend to do so. This time, however, even fewer businesses have made projections. Companies that have decided not to give future guidance include IBM, Caterpillar and the industrial conglomerate 3M1. This was not well received by investors. In the past, shares in companies that have withheld guidance have underperformed the wider market.
The lack of corporate guidance presents a challenge for analysts who cover these companies. Added to this is the uncertain economic environment. While many analysts have begun to lower their expectation for earnings, their aggregate estimates, or consensus forecasts, tend to lag major economic data releases. This makes it likely that there will be further negative changes to analysts’ expectations in the months to come.
Looking at their current consensus projections, they expect earnings to contract sharply this year, but to recover just as quickly in 2021. Analysts, like many others, are prone to be optimistic, and investors have also been showing their enthusiasm. April was a stellar month for US stocks, with the S&P 500 Index climbing almost 13%. We, on the other hand, think there are reasons to believe that profits could dip more substantially and then be slower to recover. Strong company profit growth is often a feature of stock markets’ recovery. But it takes time – roughly ten quarters, if previous recessions are a guide – to repair all of the damage to profits.
A quantitative approach to assessing the impact to corporate earnings
We have been looking at ways to help counter the uncertainty about the earnings outlook for companies. To do so, we incorporated the findings from quantitative models that link earnings growth in an economic and financial context into our tactical asset allocation deliberations.
Our models use a top-down approach to gauge earnings growth potential, as defined by economic and financial variables, such as the global manufacturing cycle and fluctuations in the exchange rates. More specifically, this framework allows us to identify the sensitivity and time dynamics of earnings for this set of key factors.
Moreover, as the economic cycle is so relevant for earnings, constructing alternative economic scenarios is a valuable exercise. In doing so, we have recognised that the length and severity of this crisis is as-yet undefined. We have therefore tested how earnings behave under a range of different economic assumptions, which led us to three plausible alternative scenarios.
The GDP growth profile is the key factor for the corporate earnings outlook
Our baseline economic scenario follows our Research Institute’s view: as seen in Chart 1 the economic rebound takes place during the second half of 2020 and is followed by a recovery in 2021. By contrast, it is conceivable that recovery could begin in the second half of this year and is followed by a strong rebound afterwards. This is our potential upside scenario. It would likely be a result of either the aggressive fiscal or monetary stimulus measures taking place in the US and/or the availability of a successful vaccine allowing a quick and safe return to normality. Finally, a more severe recession and a recovery that takes longer than anticipated define our plausible downside scenario. Factors that could signal such an outcome would be an increase in infection levels as US cities reopen for business or long-lasting damage to consumer behaviour. Another factor could be an escalation in the already terse political relationship between the US and China.
Chart 1: Alternative roadmaps for US growth
Source: Aberdeen Standard Investments (as at May 2020).
1 Note: US GDP.
Key drivers of corporate earnings growth
Our framework suggests that the industrial cycle – both domestic and global – is the most significant driver of US corporate earnings. As shown in Chart 2, during the global financial crisis (GFC), for example, growth in rolling 12-month trailing earnings per share (EPS) closely shadowed the collapse in industrial production. Afterwards, they improved in tandem. Last year provided further evidence of this relationship, as EPS growth slowed in line with a deceleration in the global manufacturing cycle.
Given the nature of this crisis, the recession is likely to be more severe for services than for the industrial sector. This means that in the short-term, growth in industrial production will mirror the sharp economic contraction more closely.
The currency implications
The behaviour of the US dollar is also very important. Usually, a strong dollar equals weaker company profits. It gives US consumers more purchasing power to buy goods overseas and hurts international sales for US companies. The dollar was in a strong position when the crisis began. If it remains strong, as investors prefer the safety of holding dollars, it could act as another drag on corporate earnings over the coming quarters.
Our models use three different predictions for the trade-weighted dollar. Our baseline scenario assumes that the dollar will drop 6% against its peers in2020. On the other hand, in our downside prediction, we assume that the dollar will appreciate a further 12% this year. This gain is slightly less than the one that occurred during the GFC (around 16%), reflecting the already-strong stance of the currency. Finally, our upside model supposes that the dollar could weaken by 15%. This is similar to what happened during the recovery from the GFC.
Chart 2: We expect the collapse in global manufacturing growth to be the main driver of earnings' contraction
Source: Federal Reserve Bank of Dallas (as of May 2020).
Labour costs are another important driver of earnings. In April, the US unemployment rate reached a record high of 14.7%. Since mid-March about 38 million unemployment insurance claims have been filed, suggesting that the unemployment rate could reach up to 20%. It seems likely that labour costs will fall in response, providing one element of relief for company profits. This relief is marginal, however. It is true that higher labour availability makes labour cheaper, but high unemployment and weak consumption are likely to have more damaging implications for companies’ revenues. Given the characteristics of the labour market in the US, we assumed across all scenarios that US unit labour costs will contract at a 4% pace, the same rate as during the GFC. This suggests that, given the speed at which job losses have taken place, employment is unlikely to recover rapidly even in the most benign scenario.
Our earnings growth projections for this year and next
We believe that the most likely outcome is that earnings will contract by about 35% this year, and recover at a similar pace in 2021. This reaffirms the point we made earlier: yes, analysts’ consensus earnings estimates have moved lower, but they still need to catch up with economic reality.
This result also indicates that by the end of next year we expect the level of earnings to remain below the pre-corona crisis level.
If a prolonged and more severe recession materialised, we could see an unprecedented collapse in earnings of 60% this year; the recovery in 2021 would be stunted at just 25%.
Meanwhile, our more optimistic model only really distinguishes itself in 2021. It posits that earnings will increase by 50% next year, having fallen around 30% in 2020.
As always, making forecasts is a complex business, but it is especially so during a crisis like this one. Our projections are all built on quantitative findings related to sensitivity analysis and time dynamics. These findings are complemented by our qualitative judgement of the set of circumstances that are plausible and the likely indicators of such circumstances.
As mutually exclusive scenarios, only one can come to fruition. Nevertheless, determining an array of plausible outcomes has proved to be a very useful exercise in this environment of uncertainty.
Chart 3: The path for EPS Growth in USSource: Aberdeen Standard Investments (as of May 2020).
In the past, shares in companies that have withheld guidance have underperformed the wider market