Earnings season brings micro relief

Another week into lockdown, and it may be starting to feel a little like business as usual. Even the S&P 500 has calmed down a bit, having stayed in a relatively tight trading range with daily moves limited to around 3% for the past few weeks.

This reflects a subtle shift in the market’s focus from the macro issues of the economic shutdown and the policy response, to more micro topics as the first quarter’s earnings season has begun. While it’s still early days, we can already draw a few lessons.

So far, US companies with more domestic profiles have tended to report better results than their more export-orientated peers. This arguably fits with US purchasing-manager indices (PMIs) holding up better than in other developed markets, and can perhaps be explained by the later start to the shutdown and associated disruption in the US than in Europe and Asia.

A second source of micro relief has been the fact that most companies are still beating analyst expectations. While this seems surprising given the circumstances, the same occurred during the depths of financial crisis. Yet we should not get too excited by this, either. The game of companies guiding analyst estimates down to levels that can then be beaten occurs in any market environment.

Bias doesn’t make us buyers

Indeed, with many companies understandably refusing to provide guidance, analysts are flying blind. This presents a new challenge to sell-side desks that rarely diverge significantly from company guidance. In the absence of such guidance, we would expect the natural bias of bottom-up analysts will be to err on the side of optimism and underestimate the earnings decline. Combined with our own work on the earnings outlook, this makes us cautious.

Another bias common on Wall Street could also lead to a more optimistic consensus than is justified. Analysts’ forecasts will have to include implicit assumptions about the duration of the lockdown and the nature of the economic recovery. Given analysts’ typically bullish tendencies, their base-case assumptions are likely to be sources of further downwards earnings revisions beyond this reporting season.

The end of the first quarter did include several weeks under the lockdown, so we now have a better idea of what corporate activity looks like under these restrictions and how it will ultimately show up in their quarterly filings. However, projecting forwards from the experience of these few weeks still requires a lot of judgement on businesses’ operating leverage, which determines how the revenue hit from lower activity levels translates into earnings. This is often underestimated too.

Taking all this together, while analysts are currently busy cutting their forecasts, I expect the bottom-up consensus will remain overly optimistic. The trend of downward revisions should have further to run beyond this earnings season. The recent micro relief may prove to be just that – micro.