Early Q2 US Corporate Profit Results
We have just had the first busy week of Q2 profit reports from S&P500 companies. So far, 119 constituent companies have reported Q2 EPS. The following profile has emerged: 67% of reporting companies have beaten expected EPS, but only 38% have beaten revenue estimates. Over the past 4 years, the average incidence of companies beating EPS estimates at this early point in the earnings season is 68%. On the surface, the current reading looks in-line with recent norms, but it cannot disguise the fact that expected yearly growth for Q2 S&P500 operating EPS (+2.7%) will be the lowest for the current profits cycle. Thus far, aggregate earnings for reporting companies have exceeded expectations by 5.1%. Over the past 4 quarters, the S&P500 operating EPS has exceeded expectations by 4.8%. The biggest EPS beats to date for Q2 are found in consumer discretionary and financials, where aggregate Q2 earnings appear to be beating estimates by 11%.
Early Q2 Top-line Line Beats Far Less Impressive
We are in the early days of the reporting season for Q2 profit results. Nonetheless, the incidence of S&P500 constituents beating top-line estimates in the first 20-days of the reporting season has fallen to its lowest level since 2009 Q1. Just 38% of reporting companies have managed to beat top-line estimates. There appears to be particular weakness in beating revenue estimates in industrials and health care. Since 2008, the average incidence of companies beating sales estimates at this stage of the reporting season has been 56%.
There are many reasons that one can cite to account for the seemingly disappointing incidence of top-line beats. The easiest factor to blame is the slowing global economy. The UK and eurozone economies are clearly experiencing difficulties. Furthermore, emerging market economies have also joined the slowing train. China’s growth rate has, for example, fallen nearly 200 basis points in 12-months. There is also the important issue of the exchange rate: the trade-weighted US dollar exchange rate rose +3.5% in Q2, implying a further drag from foreign-sourced revenues.
New H2 Earnings Expectations Being Formulated
Since the start of Q3, earnings expectations for H2 have been revised down. There is now expected to be zero growth in S&P500 operating EPS in Q3, although Q4 EPS is expected to grow a healthy +12.2% year-over-year. So far, 29 out of the 119 companies that have reported Q2 results have also issued negative/positive guidance for Q3: 24 companies have issued negative guidance, while only 5 companies have so far issued positive guidance. It implies an 83% negative component to total guidance so far for Q3. This would compare unfavourably to 70% and 60% for Q2 and Q1, respectively. The bulk of the negative guidance has been in the information technology and consumer discretionary sectors.
US Economic Cycle Critical to Profits and Equities
The relative lack of Q2 top-line beats so far is hardly surprising: economic data in Q2 was overwhelmingly suggesting a global slowdown. The forces that have helped to produce elevated US profitability, namely strong foreign-sourced profits and financial sector profits, have run their course, at least for now. Confidence about the durability of US economic growth was relatively high at the start of Q2. This has, however, been subsequently undermined by disappointing labour market data and continued concerns about the fate of the eurozone. It is easy to appreciate why S&P500 Q2 EPS estimates were lowered during the quarter.
Risky asset markets detest uncertainty. The rise in uncertainty about the future growth path of the US economy is now the most serious problem for equity markets, and an apparent lack of leadership by the Fed has also not helped to quell risk aversion. Attention is firmly fixed on the US economic cycle: profits at domestic non-financial corporations have so far held up okay. During his Q&A session at his semi-annual testimony on monetary policy, Fed Chairman Bernanke believed that the tightening in fiscal policy in 2013 under the fiscal cliff scenario would produce a “mild recession.” History has always proved that recessions, however mild, tend to crush corporate profits. Some commentators have now significantly raised their recession probabilities for 2013. Against this backdrop, the level of confidence that investors can attach to 2013 earnings expectations should seemingly be low. P/E multiple expansion becomes impossible to justify under these circumstances. Future Quantitative Easing and Equity Prices The Fed Chairman did not use his semi-annual testimony on monetary policy to launch an official inception date for a third tranche of quantitative easing. It was not a disaster for equity prices: the underlying tone of early Q2 earnings results were more than a sufficient offsetting force. Moving forward, if it becomes obvious that US growth is slipping further in Q3, then the Fed will not hesitate to expand its balance sheet.
Who benefits from quantitative easing? The aim of quantitative easing is to boost the broader economy, not just financial speculators. The impact of quantitative easing on bond markets is simple to quantify, namely the size of purchases and the commensurate reduction of open-market duration risk. In the case of equities, however, the supposedly beneficial impact of asset purchases is often priced-in before the announcement. Equities work on a very simple transmission mechanism: quantitative easing will boost the economy and de facto corporate profits. Does quantitative easing really boost the broader economy?
The Impact of Quantitative Easing on the Broader Economy
The efficacy of quantitative easing on the broader economy is, not surprisingly contentious. There is not a universally accepted definition as to what constitutes quantitative easing. Under the Fed, quantitative easing initially became synonymous with “credit easing”: asset purchases were originally aimed at infusing liquidity into otherwise moribund markets. The Fed’s decision to purchase mortgage backed securities in the wake of the financial crisis is an excellent example of this strategy. More recently, however, the Fed has been focussed on “money printing” by incepting and extending Operation Twist. What has been the impact on the broader economy?
Recent research by the San Francisco Fed has cautiously concluded that quantitative easing has had a beneficial impact on the broader economy. For example, the US unemployment rate would be 1-.1.5% higher without the asset purchases. The reason is simple: real GDP in the US may have been boosted by as much as 3% due to the inception of two tranches of quantitative easing and Operation Twist. The conclusion should be as follows: without quantitative easing, the post-Great Recession recovery would have been even more tepid. Against this backdrop, the P/E multiple contraction that has occurred over the past 5-years would arguably have been even greater!
Summary and Conclusions
Early reports for Q2 earnings indicate a much lower incidence in beating top-line estimates. The slowing global economy in Q2 is the most likely culprit. There also appears to be a recalibration of Q3 earnings expectations by analysts in place, based on negative guidance by companies.
Given the slowdown in the European and emerging market economies, there is now increased scrutiny of the prospective developments in the US economic cycle. The Fed Chairman believes that the fiscal cliff scenario would produce a mild US recession in 2013. The consequences for corporate profits could, however, be significant.
The Fed will have no hesitation in expanding its balance sheet should the US economy slow further in Q3. There have been benefits imparted to the broader economy from quantitative easing. The most important implication of quantitative easing for the US equity market has been to limit the extent of P/E multiple compression over the past 5-years.
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