Post Covid-19, what could 2021 earnings look like?

03 April 2020

5 minute read

By Julien Lafargue, CFA, London UK, Head of Equity Strategy

The spreading coronavirus pandemic has savaged equity valuations despite unprecedented fiscal and monetary responses around the world. What can equity investors do as the pandemic unfolds to prepare for an eventual rebound in earnings and valuations?

No consensus

For long-term investors, the trajectory of earnings matters much more than the short-term gyrations in valuations. However, at this point in the spread of the coronavirus pandemic, making assumptions on future profit growth is almost impossible. Even companies are withdrawing 2020 guidance by the dozen.

When it comes to global equities, the bottom-up consensus forecast points to 6.5% earnings growth in 2020 and 11.5% in 2021. These numbers should be bluntly ignored. Looking at top-down strategists, revisions have been numerous in the past few weeks and numbers currently range between a 5% decline to a 20% drop in earnings this year. Few venture to say a word about 2021.

History as a guide

We face an unprecedented situation and history may not be a reliable guide this time around. Yet, this is what most investors will look to in the search for some guidance. Considering the last 30 years, global equities have suffered three major earnings drawdowns (1992, 2000 and 2008). In these periods, earnings, on a trailing basis, contracted by around 35%.

While investors usually rely on forward looking measures, in current circumstances, we believe this is too subjective. Based on this measure, it suggests that having dropped around 30% from their recent peak, market valuations already reflect most of the upcoming downgrades.

Based on this measure, it suggests that having dropped around 30% from their recent peak, market valuations already reflect most of the upcoming downgrades

It’s all about the rebound

Unfortunately, attractive valuations are usually not sufficient to justify a rally. In addition, investors need to see the light at the end of the tunnel, in the form of an earnings recovery, before a sustained bounce is likely.

Based on the information available, one could reasonably assume that, once the Covid-19 pandemic is under control, economic activity will gradually return to normal (as seems to be happening in China). Thanks to a significantly depressed base, year-on-year profit growth should then be meaningful. We are unlikely to make up for all the economic damage caused by the coronavirus outbreak due to some lag effects (unemployment staying durably more elevated for example). Nonetheless, it appears reasonable to anticipate a strong recovery in earnings.

Magnitude and timing

The magnitude of the eventual rebound remains uncertain and so does its timing. Here, again, we can turn to history for clues but because of the unique nature of the threat we face, any indication is to be taken with a pinch of salt.

Never have we seen such a violent bear market (appearing in just 16 days from peak), nor the level of stimulus central banks and governments have already committed to. Still, it usually takes a few years (around 3.5 on average) for earnings to recoup their drawdowns. While this number may not bode well for 2021 earnings, it also means that, based on historical patterns, earnings could grow at a compound rate of around 15% in the next three years.

Question marks remain around valuations

While earnings dictate long-term upside potential in equities, valuations move in tandem with the short-term price action and are influenced by many factors. As such, we are, just like valuations, tempted to revert back to the mean which, in the case of global equities, is around 15.5 times forward earnings and 18.2x trailing.

Assuming earnings collapse by 35% before recovering half of these losses by the end of 2021, then the market appears fairly valued in our opinion. However, this simple exercise does not take into account that several trillions dollars-worth of stimulus has been pumped into the economy and that interest rates are as depressed as ever. This would suggest that valuations have room to stay above their historical average for the foreseeable future.

Time for value?

While some investors may prefer to hide in the current environment, some are on the hunt for bargains. Usually their attention is focused on the sectors and companies that have been most exposed to the threat that caused the initial sell-off.

This would have been technology in 2000 or banks and real estate in 2009. Indeed, “value” stocks, whose earnings are likely to be erased during a recession, tend to enjoy the strongest initial rebound. However, looking at what happened in the US in 2009, in order to benefit from this outperformance of value, good timing was essential (see chart).


Focus on quality

Should our base case play out (limited long lasting impact of coronavirus with a recovery starting in the second half of this year), we would expect value to outperform initially. Financials, energy (assuming a quick recovery in oil prices) and travel and leisure are likely to lead the way.

Europe would also likely outperform the US. However, we would see this as a trade rather than a new paradigm. In addition, we while we would tilt towards value, we would do so with an eye on quality as the shockwaves from the Covid-19 crisis will likely take time to work their way through.

For the above reasons, proceeding with extreme caution seems warranted when it comes to picking up stocks in airlines or cruise line companies, for example. Many may need to be bailed out and still may not survive in the long run. In our opinion, whether it’s value or growth, in recession or expansion, quality remains key to enjoying the long-term potential benefits of compounding growth.

Whether it’s in value or growth, in recession or expansion, quality remains key


Market Perspectives April 2020

Financial market sell-offs, in the face of unprecedented policy measures to fight the effects of the Covid-19 outbreak, suggest any rebound may be a few months away.


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