US Q2 earnings season preview: Support from the base

July 30, 2021 08:52
Photo: Reuters

The US earnings season has kicked off with large cap financials dominating the releases. The coming weeks will see a majority of US corporates reporting with slightly more than half of the S&P’s constituents announcing their Q2 results before the end of July. Looking at bottom-up consensus expectations, year-over-year growth rates for the S&P 500 appear ambitious at 62%. However, this is largely a result of the depressed base levels in Q2 2020, when earnings declined by more than 30% due to the pandemic. More revealing are quarter-over-quarter growth rates, which the market consensus expects to turn negative in the second quarter, after three consecutive quarters of double-digit increases.

Interestingly, the picture looked very similar at the beginning of the first quarter earnings season. Back then, bottom-up consensus expectations projected earnings to come down from Q4 2020 levels, only to be surprised with a record 86% of companies beating analysts’ forecasts and seeing S&P 500 earnings rise by 12%. Although the beat rates for Q2 earnings may moderate somewhat from the levels we have seen in the past three quarters – the strongest phase of the pandemic rebound – it does appear likely that earnings will show a tick higher vs. Q1 at the end of the season.

In terms of sectors, energy and materials are expected to see the largest annual and quarterly growth rates, driven by the rise in oil and other commodity prices. These two are also the only two sectors with consensus expectations for Q2 earnings above Q1 levels. Although not as much as energy and materials, annual growth rates for other cyclical sectors are also set to benefit from base effects, while more defensive sectors are expected to lag in terms of growth rates.

As mentioned above, to date, it has mostly been financials which have released their Q2 data. While they have broadly beaten expectations on earnings, this did not translate into benefits in terms of performance. US banks have been the second weakest sector as at the second week of July (only energy was weaker). The renewed decline in rates has clearly been a headwind, but more importantly, the quality of earnings is raising doubts about their sustainability. Non-recurring items, such as further reserve releases and non-structural factors, such as IB fees, have helped to boost the bottom line, while structural revenue drivers were generally weak. Net interest income and loan volumes, which would indicate a more fundamental improvement of the business, often came in below expectations. These weaker indicators may have limited direct implications for the quality of earnings in other sectors, but could also mean that bank earnings are set to slow once the current re-acceleration phase has passed.

In terms of the outlook for earnings, we find it difficult to imagine an acceleration of earnings upgrades similar to that after the Q1 season. Two principal factors are at work here. Firstly, the revision rate has been highly elevated throughout the first half of 2021, accounting for a remarkable 9 percentage-points of the 16% market return since the beginning of the year.

Secondly, the peak in the acceleration phase of the US macro cycle has likely passed in Q2, indicating a moderation in earnings upgrades for the months ahead. Given that the US market has already moved far ahead of earnings expectations, reflecting the re-rating over the past two years, US equity returns are set to be a lot more moderate than they were during the first half of the year.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin