5 things you need to know for this earnings season
The second-quarter earnings season will kick off next week and investors can brace for more weak numbers and some new issues to keep an eye on for the rest of the year.
S&P 500 companies are expected to post their sixth straight quarter of declining sales and fifth straight quarter of declining earnings, according to FactSet. That marks the worst five-quarter streak since the period from the third quarter of 2008 to the third quarter of 2009.
But with that news already baked into share prices, investors will be razor-focused on outlooks—and providing guidance will be tricky for some companies.
The UK’s shock vote to “Brexit”– leave the European Union—has created a cloud of uncertainty that has spread far beyond those companies with exposure to the UK and EU.
See: The Brexit currency domino effect isn’t over yet
Brexit has caused the dollar to reverse the weaker tone seen for most of the quarter and strengthen against major rivals, a trend that continued Friday after a stronger-than-expected June jobs report. It has pulled the recovering oil price down from recent highs and battered markets across Asia. Before the jobs report was released, it had put the Federal Reserve on hold with its interest-rate hikes, and even prompted talk of a U.S. rate cut that would only prolong the ultralow rate environment that has decimated returns for savers for the past eight years.
See: Fed rate hike back on table — but likely not July — after strong jobs report
And that’s not the only bad news.
China’s slowing economy has remained a worry, and been joined by troubled Latin American economies, such as Venezuela and Brazil, which is struggling with the Zika virus outbreak and glitches in its preparations for the summer Olympic Games.
Companies can expect heightened scrutiny of their numbers, too. Since the first-quarter earnings season ended, the Securities and Exchange Committee has formed an internal task force to closely review the widespread use of non-GAAP numbers in earnings reports, or those that don’t comply with Generally Accepted Accounting Principles, or GAAP.
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And even without all of those factors, companies have come through a period of asset sales and lowered capital spending, and have spent record sums buying back their own shares, leaving them with little ammunition to spur growth.
Still, analysts agree that the first quarter likely marked an earnings trough, and that numbers will be better, or at least less bad, in the second half. S&P 500 companies are expected to post a 5.5% decline in per-share earnings for the second quarter, narrower than the 6.6% decline posted in the first quarter. Sales are expected to fall 0.9%, after a decline of 1.5% in the first quarter.
Bank of America Merrill Lynch is cautioning against over-optimism.
“With the S&P 500 just shy of its all-time high, we remain near-term cautious, as the market is likely already anticipating an earnings rebound,” analysts wrote in a note. (The index bolted to that high in late trade Friday, in a wave of buying driven by the jobs report.)
The energy sector remains the biggest headwind to overall earnings growth, and is expected to show a decline of 81%, a big negative but a significant improvement over the roughly 107% decline posted in the first quarter, according to S&P Global Market Intelligence.
That s not enough of an improvement to make S&P 500 index growth turn positive — excluding the energy sector, growth is still a negative 0.6%, according to S&P.
Here are five things to expect this earnings season:
The Brexit effect
The word “Brexit” showed up just 29 times in first-quarter earnings transcripts, according to Bank of America, suggesting U.S. companies were relatively unfazed before the referendum. For most of the lead up to the vote, the “remain”camp was widely expected to prevail, with sentiment only turning in the days before ballots were cast, creating a bigger shock when the “leave” camp won.
See also: Brexit chills global M&A as companies struggle with currency, trade uncertainty
Also: Will Brexit block a tech M&A boom and IPO resurgence?
Read: Apple could take a hit from Brexit
Analysts are expected to pepper executives with questions about what Brexit means for their companies on conference calls, but they are unlikely to get a satisfying response. Not even the UK government is currently able to say what could or should happen next as they brace for negotiations with Brussels that are expected to be long and contentious.
See : Brexit uncertainty is starting to drive companies to disclose possible impact
Fitch warned Thursday that issues that have not even arisen yet could become major stumbling blocks. Uncertainly will form the backdrop for talks that could last two years and cover every aspect of the UK’s relationship with the trading block. That is expected to weigh on UK and EU growth, which will likely have a knock-on effect on other economies.
Read: IMF slashes eurozone growth forecast due to Brexit
For U.S. companies, the financial sector will be hit hardest, with the big U.S. banks already warning they may be forced to relocate at least part of their business to EU countries to retain the EU “passport” that allows them operate in all EU member states without requiring separate regulatory oversight.
“We view indirect effects of Brexit and uncertainty related to U.S. election (i.e., a pause in activity as companies wait and respond to the outcome) as potential downside risks for growth outlook,” said J.P. Morgan analyst Dubravko Lakos-Bujas. “With this in mind, management guidance during this earnings season will be instrumental in determining the magnitude of negative revisions to current aggressive forward estimates.”
Current estimates are for earnings to return to growth of 7% in the fourth quarter and 14% for 2017, he said.
Outside of banking, luxury goods makers and retailers are expected to take a hit, given their exposure to the UK and EU. Wells Fargo said Friday the roughly 15% depreciation in the pound since the vote is bad news for watchmaker Fossil Inc. FOSL, +4.60% Michael Kors Holdings Inc. KORS, +2.41% Ralph Lauren Corp. RL, +1.62% TJX Cos TJX, +2.19% and Urban Outfitters Inc. URBN, +3.67% among others, and that was just based on the currency move. About a third of Fossil sales are generated in Europe, and about a fifth of Ralph Lauren’s are made there, creating another headwind in a market already grappling with discounting and shifts in shopping behavior.
Before Brexit, the dollar was helping earnings for a change
Multinational companies have gotten used to using the argument in recent quarters that results would have been a lot better if it wasn’t for the dollar’s strength. It’s not our fault, the companies say, it’s just math.
A rise in the dollar relative to the currencies of countries in which a company does business reduces the value of profits and sales derived from those countries. A strong dollar also tends to increase prices of U.S. exports, reducing their appeal to overseas customers.
For the latest quarter, however, be wary of companies that blame the dollar for their woes. The ICE U.S. Dollar Index, which measures the dollar’s value against a basket of currencies of major U.S. trade partners, rose sharply in the final week of the quarter in the wake of the Brexit vote to close June 30 up 0.5% from a year ago. But the average daily price during the quarter of 94.53 was 1.5% below the average price in the second quarter of 2015 of 96.00.
The average price of the euro relative to the U.S. dollar increased 1.5% from a year ago, while the yen shot up 12% against the dollar. Meanwhile, the average price of the sterling-dollar exchange rate was down 7.3%.
And it’s not a given that a strong dollar is bad for earnings and stock prices. The dollar index soared 23% from the end of the second quarter of 2014 through the first quarter of 2015, and the S&P 500 climbed 5.5%.
“The dollar has been more deterministic since the global financial crisis due to its ‘safe haven’ status, not an equity market indicator,” Tobias Levkovich, chief U.S. equity strategist at Citigroup, wrote in a note to clients.
As for the dollar’s post-Brexit gains? Citigroup’s global strategy team wrote, “we don’t expect this to continue much further.”
Low rates aren’t helping
The drop in borrowing rates, as longer-term Treasury yields extended declines toward record lows, may have helped boost stock prices, but hasn’t been the boon to earnings that many may have hoped.
In fact, Morgan Stanley strategists said this week that they have become more cautious on U.S. stocks, after three years of being bullish, partly because of lower yields on benchmark 10-year Treasury notes. History suggests that “multiple expansion occurs with higher real rates,” Morgan Stanley chief U.S. equity strategist Adam Parker wrote in a research note.
Despite the strong June jobs report, the yield fell to 1.375% on Friday, just a touch above record low close of 1.367% earlier in the week. In contrast, the aggregate yield on the S&P 500 index was 2.140% on Friday, according to FactSet.
Some companies may cite concerns over the message of low yields—slowing U.S. growth and/or growing international recession risk—for downbeat earnings outlooks.
One of the sectors with the most to lose from falling or low longer-term interest rates is financials. Lower yields reduce the spread between what banks earn on funding longer-term assets, such as loans, with shorter-term liabilities.
Financials have a 15.7% weighting within the S&P 500, according to S&P Dow Jones Indices, which makes them the second biggest of the index’s 10 key sectors.
The China syndrome
China is expected to show up in many earnings reports, as companies update investors on how their business is performing there. China has transformed from being mostly a source of cheap goods and semifinished products for U.S. companies to a promising market with a burgeoning middle class that is now embracing consumer goods.
The Chinese economy is showing signs of strain after its rapid expansion, and there are widespread concerns about heavy leverage in its stock market and the burden of nonperforming loans for its banks.
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In the first quarter, weakness in China was behind the first decline in sales in 13 years at giant Apple Inc. AAPL, +0.77% the world’s biggest company measured by market capitalization. Investors punished the stock, which fell 8% immediately after the news, wiping out more than $ 40 billion in market cap.
Apple is now appealing a patent ruling that was won by a Chinese smartphone marker, which had temporarily blocked it from selling its products in Beijing.
Emerging market problems aren’t retreating
Although the overall revenue exposure of the S&P 500 companies to emerging market economies has decreased slightly to 11.2% this year from 11.6% in 2015, according to FactSet, the health of those economies remain a significant factor in the guidance that companies provide.
That’s the bad news.
“Our economists remain concerned about the emerging market economies,” Citigroup’s global strategy team wrote in a recent research note. The team expects emerging-market gross domestic product growth of 3.7% in 2016, hurt by contraction in Latin America and slowing growth in China.
Among some of the S&P 500 companies with the highest revenue exposure to emerging market economies, according to data provided by Citigroup, include Mead Johnson Nutrition Co. MJN, +1.63% at 71%, Wynn Resorts Ltd. WYNN, +0.89% at 70%, Lam Research Corp. LRCX, +3.46% at 68%.
There is some good news. Analysts have become a little more optimistic on the outlook for emerging markets in recent weeks, especially for Brazil, which has been one of the most distressed markets of late.
The iShares MSCI Emerging Markets exchange-traded fund EEM, +2.16% has run up nearly 6% in the two weeks since the Brexit vote, and has gained 7.1% year to date. Meanwhile, the Brazilian real has appreciated 2.5% against the dollar in the past two weeks and 17% so far this year.
“Since the peak of the political turmoil is behind us, we think the [Brazil] economy will start to stabilize in the second half of the year,” Morgan Stanley economists wrote in a research note.