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US profits and the coronavirus pandemic: what to expect?


Irene Lauro

Irene Lauro

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The coronavirus outbreak is set to deliver a sharp shock to the global economy. Governments and central banks have started to loosen policy in a bid to prevent a major downturn. The Federal Reserve cut interest rates to the effective lower bound of 0%-0.25% and announced a new round of QE and emergency measures to improve liquidity in the Treasury and dollar funding markets, but this has so far failed to bolster investor confidence.

Concerns over a a prolonged slump remain elevated and have dramatically shaken global markets. As of 24 March, the S&P 500 is down almost 30% from its peak on 19 February (source: Refinitiv DataStream).

Chart 1 shows that the tailwind of multiple expansion that pushed equity returns higher in Q4 has now come to an end and has reversed its course. Most of the recent decline in returns has been driven by a severe de-rating, as the price investors are willing to pay for stocks has declined dramatically.

The chart also highlights that earnings per share (EPS) have barely moved during the S&P 500 rollercoaster of the past two quarters, calling into question whether earnings still matter for equity returns.  

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Should we still care about earnings?

Using regression analysis, we try to investigate whether earnings growth is still a key driver of equity returns. Looking at quarterly data from the late 1990s, we find a positive and significant relationship between equity returns for the S&P 500 and operating EPS, reassuring us about the role of earnings in determining equity returns.

More interestingly, when we restrict the time window of our analysis and focus only on the post-financial crisis period, the correlation between the two variables improves meaningfully as the R squared, an indicator of the model’s explanatory power, more than doubles.

This suggests that operating earnings have actually become a more significant driver of stock prices in the last decade.

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With US market returns likely to be driven by the real state of the economy and its corporate sector, our earnings outlook suggests that equity investors should remain cautious.

Amid a slowing economy, US corporate profitability deteriorated significantly in 2019. This year, US companies have already started to issue profit warnings and lowered forward guidance on the back of the coronavirus outbreak.

Analysts have started to adjust their EPS forecasts in recent weeks, but estimates for S&P 500 EPS growth remain between 10% and 14% for this year. However, we think that a further decline in corporate earnings is highly likely given the growth impact of the coronavirus pandemic. As a result, earnings are likely to suffer this year.

We can forecast economic profits based on top-down economic factors. Earnings per share (EPS) for the S&P500 (the large cap US equity index) will be more volatile. This is because of the effects of a company’s borrowings and write-offs. However, we would expect the direction of profits to be similar and so we can make an estimate of operating EPS for the S&P 500.

Our 2020 outlook appears gloomy, but expect a rebound in 2021

Our top down approach allows us to forecast the share of economic profits in GDP via profit margins and capacity utilisation. While the forecast for capacity utilisation is being driven only by real GDP growth, the margins forecast is affected by growth in labour costs, prices and productivity.

Our forecasting model suggests that caution on US earnings in the following quarters would be appropriate, as we expect economic profits to continue deteriorating throughout this year.

We are forecasting a recession in the first half of 2020, where economic activity is expected to fall dramatically in Q2 as a result of the disruption. When US economic growth falls below trend, capacity utilisation drops, putting severe downward pressure on pre-tax economic profits. There is likely to be a V-shaped recovery once the virus outbreak fades, but our baseline forecast is for a drop of more than 60% of pre-tax economic profits in Q2.

The pre-tax economic profits decline for 2020 is expected to be of 16.1% year-on-year (y/y) and this will translate into a meaningfull deterioration in S&P 500 operating earnings per share – we forecast these to shrink 14.4% this year.

As activity starts to recover in the second half of the year, so will capacity utilisation. We expect economic profits to bounce back in 2021, growing more than 47% y/y. That would be good news for equity investors, as we forecast S&P 500 operating EPS to grow more than 47.4% y/y next year.

Additionally, the “secular stagnation” era of low or no growth could finally come to an end thanks to the substantial boost to growth provided by fiscal policy. Once investors realise this and start to factor in the EPS recovery, equities could rebound substantially when the shock to the economy dissipates.

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Is the market pricing in a recession?

The potential for a longer slump in activity is elevated, as there is still a lot of uncertainty around when the outbreak will be under control. The coronavirus pandemic could lead to a more persistent reduction in activity with more severe disruption to supply chains and a prolonged interruption in travel and tourism activity.

An economic recession (i.e. two quarters of negative growth) is a growing risk, and this does not appear to be priced in by the market.

Valuations are looking more attractive than a couple of weeks ago, with the US stock market currently trading on much cheaper price-to-earnings (P/E) ratios. Indeed, the S&P 500 traded on a multiple of over 23 times at the end of January and this has since dropped to around 16 times as of 23 March (source: Refinitiv DataStream).

However, despite this significant de-rating, valuation multiples for the S&P 500 look still too elevated when compared to previous recession lows.

During the global financial crisis, the trailing P/E ratio dropped to a 20-year low of 9.6 in November 2008. Currently, trailing and forward P/E ratios are still close to their post-financial crisis average of 18x and 15.5x, respectively.

This suggests that US equities have not fallen far enough to price in the risk of a severe economic recession.

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The views and opinions contained herein are those of Irene Lauro, Economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.