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Hope springs eternal

14 May 2020

5 minute read

The COVID-19 pandemic has turned much of life upside down. Companies haven’t escaped its effects. Little meaningful has been gained on their prospects from this year’s first-quarter earnings, while second-quarter earnings growth is shaping up to be even worse. But, investors’ optimism appears intact, in the seeming belief that a full, and relatively quick, recovery next year is still on the table. Is this being too optimistic?

Better than expected earnings

In the US, companies saw their earnings contract by around 12% year-on-year in the three months to March. While broadly in line with “bottom-up” consensus, it was much better than some feared, with expectations for a figure closer to -20%. Yet, only around two-thirds of companies beat expectations, low relative to a typical quarter.

From a sector perspective, divergence was large. Consumer discretionary, energy and financials faced earnings declines of over 30%, while healthcare and technology saw growth of around 6%. In Europe, although most companies do not publish their full quarterly profit and loss account, those who have reported an average decline in earnings of about -35%. The combination of a large exposure to emerging markets and earlier lockdowns can explain the underperformance versus US companies.

Very few winners

Some companies in food retail or healthcare initially benefited from the stockpiling frenzy that preceded quarantining. But, this effect was short-lived and is likely to be followed by “payback” in the second quarter. While top-line growth has been resilient, at -1.7% in the US, many companies have incurred higher costs to keep their business running, weighing on profitability.

Companies give limited financial guidance

The swathe of companies not giving any financial guidance on their prospects was the other key feature of this earnings season. As a result, investors remain blind. For the three months to June, the consensus expects US earnings to shrink by more than 35%. For the full year, downgrades have accelerated and pushed the expected contraction to -22%.

We have very little confidence in the above numbers, especially when an analysis of around 600 earnings call by US Federal Reserve researchers showed that roughly 42% of US non-financial public companies are discussing slashing investments. At the peak of the last recession, the comparable figure was “only” 25%.

Awaiting V-shaped recovery

Despite earnings forecasts being cut at an unprecedented pace, equities have been resilient. This divergence can be explained by investors’ willingness to look past 2020 and focus on the recovery expected for 2021.

The market is anticipating earnings growth of around 30% next year, taking 2021 earnings above their 2019 levels. This belief in a V-shaped recovery was fuelled by companies’ comments highlighting improving trends in early April. But we believe the market may be reading too much into green shoots like rebounding hotel occupancy levels or more credit card swipes being seen than at the peak of the crisis.

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Diversify, diversify, diversify

For the time being, we expect markets to remain disconnected from near-term fundamentals. The science around COVID-19, and finding a vaccine to it, and the hopes of an economic recovery seem to be largely driving market prospects. Yet, plenty of risks are still on the horizon, such as a possible second wave of infection, renewed lockdowns and long-lasting damage to consumer confidence.

We remain squarely focused on maintaining proper diversification in portfolios and taking advantage of the elevated volatility levels likely to persist for some time.

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