global stocks slumps

The Daily Fix

Thoughts on the market and the Q2 earnings playbook 

A new quarter and new challenges, but we start on a somewhat positive footing and while the NAS100 closed +1.2% – printing a new all-time high – the S&P500 +0.5%, but off the highs of 3127, with defensive sectors (REITS, utilities and Comm Services) outperforming – the Dow fell 0.3%.

Elsewhere, the USDX is -0.3%, with risk FX working fairly well (BRL and ZAR are up 2.8% and 1.8% respectively). The AUDUSD, by way of G10 risk proxies, sits up 0.2% and in the 58th percentile of the daily range. Growth commodities are higher, with copper continuing its uber bullish run and crude once again setting a re-test of the price ceiling at $41.00. We see implied volatility broadly lower, with our VIX index eyeing a move sub-30.

There were reasons to think equities could have been lower, with US/China relations in focus, Houston ICUs exceeding capacity and big numbers out of Arizona, California and North Carolina. However, looking at the tape and the market seemingly focused on further solid US data, with ISM manufacturing growing at 52.6 (vs 49.8 consensus), with encouraging improvements in the new orders, production and employment sub-components. Good news for equities and copper and we saw the Atlanta Fed 2Q GDPNow estimate model being revised up to -36.8% (from -39.5%).

The ADP payrolls rebounded to 2.36m, just shy of consensus at 2.9m, but it should re-enforce the notion that the balance of risk for tonight’s NFP (22:30aest) are skewed above consensus of 3.029m jobs created in June. The unemployment rate is expected to come down to a still elevated 12.5%, while average hourly earnings should fall somewhat to 5.3%.
Consider we also get the weekly jobless claims at the same time, with the market expecting 1.35m new claims and 19m continuing claims.

Lots of talk of vaccine’s, which is great for markets and the human race, with encouraging results seen from a joint Pfizer/BioNtech SE, who join the race to develop a drug with AstraZeneca and Moderna (among others).

It all sets us up for another positive open in Asia, with Aussie SPI futures +0.7%, with focus on HK which comes back online amid rising tensions on the streets. By way of event risk, its all  fairly minimal with Aussie trade balance (11:30aest)  unlikely to move the dial and little else to trouble – its really about getting set for tonight’s NFP.


Q2 earnings playbook 

I have also been speaking to a few clients about the upcoming Q2 earnings season and whether it will be a vol event. With valuations so high could this prove to be a key driver of risk. Here are a few thoughts…..

US and global equities indices have closed out what was a truly incredible Q2, with price looking remarkably like a re-run of 2009 (see chart 1) – however, with index valuation at the most expensive since the era, concerns around a spike in the COVID19 case count, a plateauing of the Fed’s balance sheet and many of the fiscal measures soon to expire, one questions where the balance of risk resides as we navigate a potentially volatile July.

Amid all these macro-focused landmines for traders to navigate we also have US 2Q earnings season due to commence on 14 July, with JP Morgan the first big-name off the rank. With moves in the US500, NAS100 and US30 so influential to FX and commodity markets don’t discount how important this earnings season could be as a driver of broad market sentiment.

Are we due to see an earnings revival?

The two key questions being asked around trading floors;

  • At what stage will the economic recovery feed through to higher earnings estimates, in turn reducing valuation and further boosting the appeal of stocks?
  • Will CEOs and CFO’s offer any insights that instil confidence that better times are ahead – a view currently portrayed in the charts of copper, crude, and equities. Or conversely are equities, while heavily influenced by Fed policy (chart 2), just too optimistic on the economic outlook and due to correct through July – a view that is perhaps better portrayed by the bond market.

Key considerations for earnings:

  1. While unsurprisingly nearly all US companies refrained from providing guidance in Q1 earnings, we’ve seen emerging evidence of an economic rebound since late April. The Citigroup Economic Surprise Index (chart 3 – this moves higher when economic data is beating consensus expectations) sits at an all-time high. We’ve also seen stabilisation in the analysts’ earnings assumptions (see chart 4), but have we hit a low point in the earnings cycle?
  1. As we can see in Chart 5, historically earnings estimates have followed the US500 with a lag of about three months. If this holds true once more, we’re eyeing a market which is facing a positive upgrade cycle. While it seems more to play out from Q3, could Q2 earnings season ignite a spark?
  1. After some extensive earnings downgrades in March, the S&P500 index valuation has blown out with the price-to-earnings (P/E) multiple ballooning out to 24.5x FY20 and 18.9x FY21 earnings respectively (chart 6) – the highest since June 2000. This alone has been one the main reasons why traders have refrained from buying US equities, or inspiring short positions, where we can also see hedge funds running a sizeable short position in S&P500 futures – although this position has recently been reduced (see chart 7).
  1. Looking at a traditional valuation is misleading and professional money managers will calculate an equity risk premium (ERP), which essentially adjusts the expected returns in the equity market for other less risky investment – Consider a scenario (in 12-months) where we see 5% EPS growth, 2-year Treasury yields rising to 20bp, investment-grade credit spreads remain at current levels. With these variables in play, a quick calculation puts the US500 ‘fair’ equity multiple closer to 21.3x.

One can then argue that the S&P500 is still expensive, but when we consider the ERP it becomes less outrageous. If 5% earnings growth proves to be conservative, and we really are due for an upgrade cycle at a time when the Fed keeps their foot on the pedal and we’re likely to hear more of a vaccine, then one could argue there is still good upside for US equities and that pullbacks are buying opportunities.

  1. Interestingly, only 49 companies have pre-announced guidance in the lead up to earnings, with 22 issuing positive EPS guidance and 27 negative guidance – Consider that 27 (negative guidance) is well below the five-year average of 73.1 companies issuing disappointing guidance.

Charts of note:

Chart 1) Comparing moves seen from 2008 to 2011 to recent price action. History doesn’t repeat but often rhythms

Chart 2) S&P500 (blue) vs the Federal Reserve’s balance sheet (red)

Chart 3) Citigroup Economic Surprise Index – At an all-time high, indicating US economic data has been consistently beating forecasts

Chart 4) Real-time EPS assumptions for Q2, Q3 and Q420

Chart 5) The S&P500 vs consensus 12-month forward EPS estimate – earnings tend to lag the index

Chart 6) Top pane – FY20 EPS estimates (white), FY21 EPS estimate (orange)
Lower pane – FY20 P/E (white), FY21 P/E (orange)

Chart 7) Weekly CFTC data – net position in S&P500 futures held by speculators.

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