The last few weeks feel like a bit of a turning point for 2020. Global and US economic data are beating forecasts and there is growing optimism that corporate profits will do likewise, especially as the second-quarter earnings season plays out in coming weeks. One strong theme supporting equity markets is that many feel the shock to companies’ profits will be brief.
Before long, the thinking goes, growth in net income will resume its upwards trend. Granted, this rebound is expected to take a couple of quarters. Analysts anticipate a decline of 21.5% in earnings of the S&P 500 companies during the current calendar year, according to FactSet, accompanied by a slide of 3.9% in revenues. But next year, profits are expected to grow by 28.2%, with revenues rising 8.5%.
All of this 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 we cannot forget the recent surge in new Covid-19 cases in a number of countries, which heightens the challenge facing many companies and their bottom lines.
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 as a result of the acceleration of digital services spurred by shutdowns, homeworking and social distancing.
The flipside to this, though, is that companies which have seen their share prices rise the most during the pandemic must be vulnerable to revenue reports that badly miss analysts’ forecasts.
If this earnings season begins to cast doubt on a V-shaped recovery, the impact is likely to fall 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 that gross public debt for advanced economies could rise beyond 130% 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, could 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.