John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or firstname.lastname@example.org
March 20, 2020
1Q20 Earnings Season: Irrelevant and Significant at the Same Time
The first quarter earnings reporting period had its official start this past week, beginning last Tuesday with dire results from JPMorgan Chase (JPM), Johnson & Johnson (JNJ), and Wells Fargo (WFC). It will be a peculiar reporting period because it is irrelevant and significant at the same time. To put it simply, COVID-19 changed everything. The Market has already priced in a tremendous amount of pain making these reports somewhat irrelevant, but the significance lays in the pace of change prospectively of loan-loss reserves of our financial institutions, for example. I will be discussing these significant inputs later in this week’s note, but first, a bit of recent history.
The Brief History of 2020
Many businesses saw the new year begin on a promising note, yet that promising start evaporated in March when the world started to more fully embrace shutdown measures aimed at curbing the spread of COVID-19.
Every facet of business life was affected one way or another, and the effect was (and still is) unlike anything that has ever been seen before. Tourism cratered; restaurant dining areas were shuttered; retail stores were closed; and major sporting events were canceled.
That wasn’t even the half of it. The fullness of this unprecedented shutdown has been extraordinary, along with the fiscal and monetary policy responses to help mitigate its impact.
The Fiscal and Monetary Forces are Ready to do Whatever it Takes to Win
Congress passed a $2.2 trillion stimulus package; the target range for the federal funds rate is back at the zero lower bound; the Federal Reserve has committed to buying Treasury and agency-backed MBS in whatever amounts are needed; and the Federal Reserve has also committed up to $2.3 trillion of lending facilities that include a willingness to lend to state and local governments and to purchase high-yield debt.
What’s more is that the Congress and the Federal Reserve have already said they stand ready to do even more. Unfortunately, the state of things suggests those aren’t going to be empty promises.
Unemployment & Consumer Spending
The depth of the downturn is starting to avail itself in the economic data, the most prominent of which has been the initial claims data. Over the past three weeks, nearly 17 million workers have filed for jobless benefits.
This has become the crux of the economic issue, because the U.S. economy — the world’s largest economy – is driven by consumer spending. If consumers are losing their jobs, like they are now, and/or are fearful about losing their job or seeing their income decline, they will pull back on discretionary spending.
That is happening in the extreme right now, which is why we are seeing forecasts that call for Q2 GDP to decline as much as 30% on an annualized basis. While first quarter earnings will be bad, second quarter earnings will be even worse.
According to FactSet, first quarter EPS for the S&P 500 is expected to decline 10%. That’s a far cry from the 4.3% growth rate projected on December 31, yet it reflects businesses and consumers alike that have been forced to abide by stay-at-home orders and the closure of non-essential businesses.
Revenue growth in many situations has dried up, but the fixed costs remain and that will hurt profit margins.
This isn’t news to the market. In fact, the stock market was spreading the news on this front when it was crashing between February 19 and March 23, losing as much as 35.4% during that time.
It has rebounded significantly in the interim, but not because of any fundamental shift in earnings prospects. It has rebounded on a shift in sentiment tied to some hopeful-sounding developments pertaining to a possible flattening of the COVID-19 case curve.
What the first quarter earnings reporting period should make clear is that there is no visibility to an earnings rebound — not one that is reasonably quantifiable in any case. There can’t be, because no one knows yet how the COVID-19 response is going to evolve in terms of an economic restart.
It’s a safe assumption that it won’t evolve quickly, easily, or comprehensively, so one should be ready to hear companies refrain from providing full-year earnings guidance. That is one element of what we expect to be a three-part reporting process for first quarter results.
The first part will address how things were going in January and February. The second part will call attention to how quickly things changed in March. And the third part will be the withdrawal of full-year guidance or a cautionary note about the inability to forecast earnings for companies that have already withdrawn their guidance. Forward guidance from firms is equally as important as the historical results they are reporting, and without this critical input we, as analysts, are left to model projections without this critical input from management. To say that we are flying blindly into the night is not too far from the truth.
Once again, the energy sector will lead the EPS downturn with a projected 51.1% year-over-year decline, according to FactSet. That performance is linked to the collapse of energy prices that has been a function of both excess supply, which was exacerbated by the price war between Russia and Saudi Arabia, and the demand destruction that has occurred due to COVID-19 response measures around the globe.
The market, however, is apt to be more concerned with — or perhaps more concerned by — the financial sector. The banks, and the loan-loss reserves they are accruing, will be the focal point in that respect. The reason being is that those reserves will provide some important insight for handicapping the pace of the economic recovery when it begins to unfold.
Large builds in loan-loss reserves should be expected given the rapid-fire climb in initial claims, but even more to the point, if banks are worried about credit quality, they will be tightening lending standards in a way that is going to impede recovery prospects. We experienced this behavior by the banks coming out of the 2008-2009 recession, but back then the bank’s were the problem. Today, they are a big part of the solution, and their willingness to lend and allocate capital efficiently and effectively are critical to not only restarting our economy, but also making sure we are on durable footing.
All ears were on JPMorgan Chase CEO Jamie Dimon who was resolutely upbeat about the U.S. economy’s long-term prospects this past Wednesday during his earnings call with analysts, but he also included a straight-shooting dose of realism when describing business conditions that, “at a minimum… the bank is assuming this period will include a bad recession combined with some kind of financial stress similar to the global financial crisis of 2008.”
Closing the Books on 1Q20 Earnings
The first quarter earnings period has started, but its relevance has been undermined by COVID-19, largely because it can’t produce any credible earnings guidance that is the signpost for a forward-looking stock market.
That point notwithstanding, the ensuing weeks will still be significant, largely because they will provide some fundamental context that starts to expose the depth of the downturn at the micro level and presumably the long-duration recovery process that can be expected at the macro level.
Next, we turn to the critical issue of how to safely restart our economy and its impact on economic output prospectively.
The Grand Re-Opening
The great reopening of the U.S. economy is at hand. Now it’s important to get it right, or it could be the prelude to a bigger and more economically devastating closing.
Thursday brought perhaps the best news in weeks on the battle against the coronavirus pandemic, with President Trump unveiling a three-phase state-driven strategy to reopen America to commerce, and companies like Gilead Sciences (ticker: GILD) reportedly seeing progress on the treatment front. What’s more, some of the hardest-hit areas like New York believe they have seen a peak in the number of new cases, and states around the country are banding together by region to plan coordinated re-openings.
How to Re-Open to Avoid Deeper Woes
For their part, investors have been buying into the reopening hype. The S&P 500 index, already up 28% after its bear-market low on March 23, leapt 2.7% on Friday to 2875 on the reopening prospects and hopes for a cure.
The urge to reopen the economy, particularly considering the staggering number of job losses and probably a double-digit decline in second-quarter gross domestic product, is understandable. But a rush to get back life back to normal raises the risks of a relapse— and setting the recovery back even further. If confidence isn’t restored, consumers may refrain from spending even after the all-clear is finally given—particularly the older Americans who are most vulnerable to Covid-19. For perspective, Americans over 55 account for 40% of consumer spending.
A measure of the GDP-weighted share of the country that has enforced varying stay-home orders, has risen to 86%. A quarter of small businesses across the country were already closed at the beginning of April, with many more shutting since then. More than a fifth of the American workforce is employed in 15 of the highest-contact industries such as health care, teachers, drivers and hair stylists—or some 27.3 million people who earn nearly $1.3 trillion annually.
Because of the risk of renewed virus spread, the public will have to be persuaded that any plan for partial reopening is safe. After all, most of the increase in social distancing in the U.S. has been a voluntary reaction to virus fears, not a response to government lockdown orders.
While the onus around lifting lockdown orders will fall to state governors, some of the burden in keeping consumers safe will rest on businesses themselves.
Even if the green light is given today, it’s too soon. I have a number of clients that run restaurant groups around the country that have all echoed the need to look out for their employees and customers, first and foremost, and have all stopped quickly or never started pick-up services where pick-up was not an existing element of their business model before COVID-19.
That’s leadership, and it is part of the reason I believe we will come out of this period stronger and more resilient.
Social distancing is likely to weigh on restaurant traffic until there is a vaccine or treatment for the new coronavirus. In Wuhan, the origin of the new coronavirus, most businesses have resumed operations. Yet restaurant activity is still down around 50%.
For many businesses, there’s no such thing as remote work or curbside service. Of the most contact-intensive occupations barbers, hair stylists, and cosmetologists top the list. According to government statistics, hair, skin, and nail salons in the U.S. generated roughly $5.24 billion in total revenue in 2018.
The impact, of course, goes well beyond small businesses. There are similar concerns for companies across the travel sector. How, for example, can airlines keep customers and staff safe in confined cabin space? Most standard middle seats on board will be blocked and flight crews will have the authority to reassign seats to improve distance between passengers.
While measures like those could help customers feel more comfortable about air travel, it’s not clear how sustainable such efforts could be for the longer term. Airlines aren’t designed to run at half-capacity. And when it comes to staying in a hotel, you can’t be sure who stayed there before you.
Some restaurant businesses already lend themselves to a world that is grappling with the disease and to an economy that will no doubt look different once there is a vaccination. Fast-food chains are well positioned, since customers often get their meals to go. Fast food chains presently take in 70% of their profits through the drive-up window.
The market is pricing in a linear recovery over the next three to nine months, but it’s likely to be more start-stop with progress and setbacks along the way. The market expects the economy to be back to normal by 2021, but that doesn’t leave much of a margin of safety, given the uncertainty.
No One Agrees on the Economic Path Forward
There is wide disparity in analyst’s outlook for economic growth which is understandable when you consider that it’s impossible to know with any level of certainty how this all plays out, and if you’re listening or reading to someone who is quite sure of themselves on the way forward, you’ve been exposed to complete hubris.
Some analysts have tried to map out reopen scenarios. On the brightest end of the spectrum, the “sunshine” analysts think it’s possible that the virus could pass without a second wave, allowing the economy to begin rebounding later this year as confidence slowly returns. At the other end is a new world espoused by a set of dystopian analysts who see rolling waves of the disease continuing to rock the globe for longer than anyone was prepared for, creating widespread social unrest, leading to increased isolationism and growing government surveillance.
As is often the case, the reality of what’s to come probably lies somewhere in the middle of this rose-colored-to-dystopian spectrum. The virus will continue to spread, and new waves will probably emerge, but consumers will resume some activities, and businesses will adapt. Those that take precautions will be better off, and so too will the U.S. economy if officials, customers, and business owners accept that attempting to resume normalcy too soon will only do more economic damage.
What This All Means to Your Portfolio Construction
Given so much uncertainty around how long the virus will linger, how quickly a vaccine will come and how effective it will be, and how the trauma will affect consumer behavior in the months and years to come, we are advising our clients to maintain a defensive tilt in their portfolios. That means overweight healthcare, critical path technology, and communications-services holdings and some caution around discretionary sectors. Additionally, we will continue to pursue companies with resilient balance sheets and a history of growing dividend payouts especially during previous recessionary periods.
We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet over the phone or by a Zoom video link. In the interim, if you would like to get something on the calendar, please send me a note with some dates and times. I would be delighted to hear from you.
Warm regards, John