The coming earnings season could bring lofty stocks down to earth


Global and US economic data are beating forecasts and there is growing optimism that corporate profits will do likewise, as the second-quarter earnings season plays out in coming weeks.

One strong theme supporting equity markets since the worst of the pandemic panic in March is that the shock to companies’ profits will be brief. Before long, the thinking goes, growth in net income will resume its upwards trend.

Granted, that rebound is expected to take a couple of quarters. Analysts anticipate a decline of 21.5 per cent in earnings of the S&P 500 companies during the current calendar year, according to FactSet, accompanied by a slide of 3.9 per cent in revenues. But next year, profits are expected to grow by 28.2 per cent, with revenues rising 8.5 per cent. That is quite a reversal, even by the perennially optimistic standards of most analysts on Wall Street.

Still, there are plenty of market watchers who think such a sunny outlook ignores the high likelihood of a slow and drawn-out economic recovery. And that is before the recent surge in new Covid-19 cases in a number of countries, which heightens the challenge facing many companies and their bottom lines.

The global equity strategy team at Citi, led by Robert Buckland, say stocks around the world may well be stuck over the next 12 months. They recommend waiting for the next dip in prices, rather than “chasing markets higher” from current levels.

Their rationale is that analysts’ forecasts for next year’s profits are about 30 per cent too high. And if that is true, the MSCI World index that tracks developed markets is trading at 24 times earnings for 2021, rather than the 17 times implied by consensus estimates. (Even that multiple looks expensive, given that before any economies began to lock down, the index was trading at 15 times.)

One justification for higher equity valuations has been the dramatic drop in long-dated government and corporate bond yields, which lifts the value of future cash flows via a lower discount rate. The prospect of much lower bond yields — and, crucially, the expectation that central banks will contain any sharp rise — has encouraged investors to boost their exposure to the technology and healthcare sectors in particular. In these areas companies are expected to prosper from the acceleration of digital services spurred by shutdowns, homeworking and social distancing.

The flipside to this, though, is that the companies that have seen their share prices rise the most during the pandemic must be vulnerable to revenue reports that badly miss analysts’ forecasts.

If there is a sense from this earnings season that confidence in a V-shaped recovery for profits is misplaced, then the impact will probably be hardest on companies with weak balance sheets, and on those whose business models depend on a full resumption of economic activity. Over the past month, S&P 500 companies carrying the most debt, relative to earnings, have been lagging rivals with stronger metrics.

But other sectors may not escape unharmed, given the cloudiness of the outlook and the huge costs of stemming the pandemic. Tax increases could loom for companies around the world because of the need to repair government balance sheets weakened by emergency spending. The IMF forecasts gross public debt for advanced economies could rise beyond 130 per cent of GDP this year. 

Wall Street may experience the lash of higher taxes sooner than other markets. Polling suggests a swing towards the Democrats in elections in November. This week presidential frontrunner Joe Biden outlined plans to reverse some of the Trump administration’s tax reforms that have given corporate profits a big lift over the past couple of years.

Further traction on this front, including a more concerted global effort to close tax loopholes, should chip away at expectations of a big recovery in profits next year, given that governments may see big gains as an open invitation to extract a greater tax share. According to Morgan Stanley Wealth Management, the sectors that have benefited the most from low taxes and the use of offshore locations are technology and pharmaceuticals — two of the stronger recent performers.

Michael Arone, chief investment strategist at State Street Global Advisors, reckons that a full reversal of the 2018 corporate tax cuts could reduce S&P 500 earnings by 7 to 8 per cent, while forcing a contraction in valuation multiples. And that goes for other markets too. The prospect of higher taxes on corporate profits, and perhaps also too on capital gains and dividends, casts a shadow over the outlook for future stock returns, he says.

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