The Big Picture–Earnings Preview

The month of July is upon us, which means the second quarter earnings reporting season soon will be too. There has been a smattering of reports already, yet the earnings reporting won't go into full swing until mid-July. Today I will provide a preview of that reporting period.

I feel compelled to do this preview now partly because I will be on vacation next week, but mostly because the timing is right to provide readers a good benchmark down the road to see how earnings growth estimates for the second quarter, the third quarter, and the fourth quarter will have changed from July 1 to the end of the second quarter reporting period.

It's All "Good"

What we know about the upcoming reporting period, and what we have often reminded readers about in our earnings previews for other reporting periods, is that the final earnings growth rate is very likely to be better than what is now projected.

One can only hope so because the current estimate for the second quarter calls for S&P 500 earnings to decline 4.9% year-over-year, according to S&P Capital IQ.

It is not unusual for the final growth rate to be two to three percentage points better than growth estimate seen just before the onslaught of the earnings reporting. That's because analysts typically undershoot with their estimates, creating a low bar of expectations for many companies to clear.

Clearly, if things hold true to historical form, second quarter earnings would still decline from the same period a year ago. That's not much to write home about, but rest assured you will see a lot written about how "good" the earnings reports have been if history repeats itself.

You're unlikely to see that written here since the objective realist in us knows "better than expected" isn't necessarily good. It can't be good when earnings are declining and when a decline for the second quarter, according to S&P Capital IQ, would mark the fourth straight year-over-year decline in quarterly earnings.

It's not good either when the latest quarterly decline is going to be driven by multiple sectors. That is, the energy sector isn't the sole cause of the downturn in second quarter earnings. Presently, there are six sectors projected to see a year-over-year decline in earnings.

Source: S&P Capital IQ

The energy sector is the biggest drag on things, but even if it is excluded, S&P 500 earnings would still be down 0.4% year-over-year.

A Pickup in Growth, Just Not in Revenue

Economic growth picked up in the second quarter. According to the Atlanta Fed's GDPNow model, real GDP growth in the second quarter is expected to increase at a seasonally adjusted annual rate of 2.7% versus 1.1% in the first quarter.

Notwithstanding the pickup in economic growth, revenue growth for the S&P 500 is expected to decline 0.9%. That will mark the sixth straight quarter that revenue has declined.

Once again, the energy sector, which is projected to see a 25.8% year-over-year decline in revenue, is playing an influential role behind that dubious distinction; however, like the earnings picture, it is not devoid of company.

Four out ten sectors are anticipated to report a year-over-year decline in revenue, with the information technology sector among the most prominent of the bunch thanks to the sales downturn Apple (AAPL) is experiencing.

Source: S&P Capital IQ

Although much has been written about the dollar's softening since the end of last year (even with its recent Brexit-related gains), the dollar was still stronger in the second quarter than it was in the same period a year ago.

To wit, the second quarter average for the Federal Reserve's nominal broad trade-weighted exchange rate index was 120.92 versus 114.82 in the second quarter of 2015. That suggests the stronger dollar still acted as a headwind for multinational companies even though it was a bit of a lessening headwind.

Currency exchange, therefore, remained a weight on revenue growth along with the decline in oil prices, a lack of pricing power, and aggregate demand that remained sluggish.

Damage Done

That's the skinny on the second quarter, which of course ended in a ball of political fire when the majority of UK voters voted in favor of the UK leaving the European Union. For all intents and purposes, that decision was a complete surprise to financial market participants and it triggered a wave of volatility in capital markets around the globe that hasn't been seen since Standard & Poor's stripped the U.S. of its 'AAA' rating in August 2011.

The dollar soared as the pound sterling sank to a 30-year low, sovereign bond yields sunk sharply in a safe-haven trade, oil prices dropped, and global equity markets got pummeled, collectively losing more than $3 trillion in market capitalization in just two days.

The S&P 500 for its part fell 113 points, or 5.3%, in the two days following the stunning Brexit vote. Just as remarkable, nearly the entirety of that loss was recouped in the next three trading sessions. Be that as it may, it's fair to say that damage has been done.

There is a heightened degree of uncertainty stemming from the Brexit vote and a weaker global economic outlook as a result of it.

Business confidence has been shaken, if not stirred, by the vote; consumer confidence has been hurt; investor confidence has been rattled by the stock market gyrations; and confidence in finding a proper political solution is still lacking.

Naturally, the leading central banks of the world have pledged to provide more stimulus if necessary. That helped put a band-aid on the bleeding, yet there still haven't been any sutures beyond that to close the cut, which will likely remain an open wound for some time.

What It All Means

The important implication of this heightened uncertainty is that it is bad for the earnings outlook.

A stronger dollar, the slippage in oil prices, and the hit to business confidence, which will curtail business spending, are going to get in the way of the second half earnings recovery that was a key tenet of the sharp rebound off the February low.

That will certainly prove to be the case anyway if these things persist -- and that was certainly the thinking in the knee-jerk response to the Brexit vote.

Looking at the earnings growth estimates for the third and fourth quarters, which stand at 2.7% and 8.5%, respectively, we can't help but think that the path of last resistance right now in the estimate trend is lower, not higher.

Accordingly, the second quarter reporting period will matter more for the guidance that comes out of it than it will for the results that are being reported. That's because the cirrus cloud of uncertainty hanging over the market pre-Brexit vote has turned into a cumulus cloud of uncertainty post-Brexit vote.

And then there is the significant matter of the U.S. presidential election in November, which is its own can of worms. We'll let that sit a little longer. Just know that it's another factor that will probably hold back business investment in the second half of the year.

What should be apparent with respect to the first half of the year is that earnings growth was weak. Actually, it will likely be said on the other side of the second quarter earnings reporting period that earnings growth was non-existent

That reality has slowed the market, but it hasn't derailed the market.

Here we are on the cusp of four straight quarters of a year-over-year decline in quarterly earnings, and six straight quarters of a year-over-year decline in quarterly revenue growth, and the S&P 500 sits less than 2.0% away from a new all-time high.

What does that mean? Interest rates, and not earnings, have been the key driver of things as the search for yield has been driving the action while earnings growth and revenue growth have been missing in action.

Patrick J. O’Hare,

S&P 500 Index is a market index generally considered representative of the stock market as a whole. The index focuses on the large-cap segment of the U.S. equities market. Indices are unmanaged and one cannot invest directly in an index

Data and rates used were indicative of market conditions as of the date shown and compiled by Opinions, estimates, forecasts, and statements of financial market trends are based on current market conditions and are subject to change without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and do not constitute a solicitation, offer, or recommendation to purchase or sell a security. Past performance is not a guarantee of future results.

Park Avenue Securities LLC (PAS) is an indirect, wholly-owned subsidiary of The Guardian Life Insurance Company of America (Guardian). PAS is a registered broker-dealer offering competitive investment products, as well as a registered investment advisor offering financial planning and investment advisory services. PAS is a member of FINRA and SIPC. 2016-25463 Exp 7/2018

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