Multi-asset allocation views: What we can learn from earnings season

On July 29, the CEOs of four of the largest US tech companies – Alphabet (Google’s parent), Amazon, Apple and Facebook – were summoned to a Congressional hearing in Washington, DC, to answer questions on their market dominance.¹ Despite winning its appeal in July against having to pay Ireland billions in back taxes, Apple faces further antitrust probes in the European Union;² at the same time Facebook has seen big advertisers suspend spending on its platform on ethical grounds. Meanwhile, Alphabet was the subject of a far from glowing assessment in a recent edition of The Economist, which delved into the company’s “mid-life crisis”.³

Despite this negative attention and relatively high market expectations, US big tech stocks have continued to offer refuge for equity investors throughout the COVID-19 crisis and managed to deliver positive surprises in Q2. Facebook’s advertising revenue continued to grow in the three-month period,⁴ and although Alphabet’s advertising revenues fell, performance in its other business lines were strong enough for it to raise its full-year outlook.⁵

The sector has been somewhat of an outlier for beating a higher bar, with generally poor earnings expectations elsewhere. Lockdowns started to take hold in the first quarter, but the economic handbrake was only really pulled up in March and April for Europe and the US respectively, making the second quarter the epicentre of the crisis.

In fact, as restrictions began to be lifted in May and June, companies typically performed better than analysts expected.

As of August 3, 320 of the S&P 500 companies had reported in the US, as had 285 out of the 445 companies covered in the European and UK Stock 600 index. Year-on-year, earnings were in fact ten per cent lower than in the second quarter of 2019 in the US, and 18 per cent in Europe. However, expectations were so low these results were 22.5 per cent above expectations in the US, and just over 20 per cent in Europe (source: Bloomberg).

A mixed picture

The level of positive surprise could be taken as an indication of companies’ resilience, making investors more comfortable in stepping back into the stock market. However, overconfidence would be misplaced: in reality, equity performance has been more mixed than these results might suggest.

The MSCI World Index was up by around five per cent over July, but by less than half a percent between July 15 and 31, after earnings reports began (source: Bloomberg). Despite company earnings outperforming, the payoff for investors has not necessarily followed.

Several factors could explain this. Firstly, market expectations are published by sell-side analysts, who may have been more pessimistic than investors. Secondly, while earnings surprised positively, sales numbers were muted: only two per cent higher than expected in the US, and four per cent below expectations in Europe. As revenues came in more or less as forecast, stronger earnings likely came through extra cost reductions. It is reasonable to question whether this is sustainable.

In the US, for instance, the government gave a large uplift to unemployment benefits, which made it less painful for companies to lay off staff earlier than they might have done otherwise. This helped performance in the second quarter, but further layoffs are not sustainable. Higher unemployment will eventually have a knock-on effect on demand, putting more pressure on company earnings, particularly if external factors like COVID-19 infection rates do not improve.

Investors are also aware that most countries are beginning to taper their fiscal relief programmes, which have been central to supporting companies since the start of the pandemic. Under the UK‘s Job Retention Scheme, companies must now contribute towards furlough payments. In the US, enhanced unemployment benefits, worth an additional $600 a week, expired at the end of July. Congress is discussing a further stimulus package, but until a new bill is enacted, unemployed Americans will no longer receive this extra income.⁶

One step beyond

Meanwhile, the continued high number of cases in the US and resurgence of COVID-19 clusters in some European cities, with the accompanying restrictions that entails, has poured scorn on the idea of a recovery to pre-pandemic levels of activity in the third quarter. While decent numbers might be achievable where economic life has been able to resume, investors are increasingly comparing activity to pre-coronavirus levels.  Our base case is for economic activity still to be five to ten per cent lower than it was pre-COVID by the end of the year, with second-round effects in terms of company solvency and long-term unemployment yet to be seen.

In the same way investors were inclined to look through worse-than-expected first quarter results, they seem to now be looking through some of the positive surprises in the second quarter. With the US stock market up 45 per cent from the lows, some of that positive surprise is already reflected in prices and it makes sense to look further ahead.

Selectively cautious

The burden of expectations for investors is high, which is why these strong earnings have not translated into strong market performance. In this context, we remain cautious, but selective about where we express that caution.

As discussed, large US tech companies have been an ongoing haven for investors and delivered positive earnings surprises. Although valuations look expensive, there is some rationale to justify them.

In contrast, we are cautious about smaller companies like US mid-caps, which face a challenging environment with historically high levels of leverage, and Japan, which is struggling in terms of economic and earnings recovery. This reflects a combination of Japan’s dependence on aspects of global trade like capital spending – where the outlook still seems to be extremely weak – and a domestic resurgence of the coronavirus.

It is important to be selective at this juncture, but areas like these face enough challenges that expressing caution does not look too costly in terms of foregoing opportunities.

Will ByteDance spoil the show?

One threat to earnings is the rivalry between the US and China. The US is now focusing on some of the big emerging market tech powerhouses, like TikTok owner ByteDance, and raising concerns over security and privacy to potentially weaken their ecosystem.⁷ Moves like these only serve to emphasise the strategic competition between the two superpowers.

Looking at the share-price reaction of the large Chinese tech companies, there is surprisingly little sign of concerns over these firms losing access to the US market.⁸ This is partly because the Chinese state is now more likely to support them by encouraging investors to buy their stock.

That makes it hard to gain a clear understanding of the performance of the Chinese stock market, or even broader economic performance in emerging markets. Indirect state intervention in the equity market is ramping up in China, blurring the price signals, which is another reason for caution.⁹ There is limited visibility on the profit outlook of those companies over the next six to 12 months.

This is why we continue to prefer credit and Europe, in particular, where we feel the profit drivers are more visible. In part, this reflects more even signs of recovery from the pandemic than in the US and some positive political developments such as the recovery fund, as discussed in our last article.¹⁰