Corporate profits around the globe comfortably topped expectations in the third quarter, helped in no small part by cost cuts, and optimism is growing that earnings momentum will carry on in 2021 even if the bar to get over is higher next time around.
Businesses have slashed expenses materially this year to cope with the fallout of pandemic-induced shutdowns. Jobs have been eliminated and capital spending has slumped. With little point in hawking goods and services to customers who can’t buy them, companies have been able to pare back sales and advertising expenditures, while travel has been curtailed in a world of working from home and Zoom meetings.
The result: Companies ranging from Mercedes Benz maker Daimler AG to motorcycle firm Harley-Davidson Inc. and Japan’s Sony Corp. surprised investors with the strength of their quarterly results. While earnings overall declined in Europe, the U.S. and Asia, the drop wasn’t as big as initially feared, and stock prices held on to their gains.
Note: Percentage of companies beating analyst earnings estimates
“I feel quite optimistic that we’ll be back to earnings levels that are the highest on record again” by mid-year, said Peter Garnry, head of equity strategy at Saxo Bank A/S. Underpinned by massive fiscal and monetary stimulus, 2021 is set to be a “much better year.”
Data from Bloomberg Intelligence shows 64% of companies in the MSCI Europe Index surpassed third-quarter earnings estimates, though only 46% delivered a beat on sales. Earnings fell by a less-than-expected 22%, much improved from the 62% fall in the second quarter.
In the U.S., earnings per share for S&P 500 companies dropped 8.6%, better than the 21.5% expected before reporting started, according to BI. In Japan, 59% of the Topix Index beat estimates, while elsewhere in Asia that reading was 56%, according to JPMorgan Chase & Co.
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The outlook for equity markets has also brightened to some degree in recent weeks. The U.S. election is out of the way and positive news on a potential vaccine has raised hopes that the economic hit from the Covid-19 pandemic will soon be over.
“By the next earnings season, much of the uncertainty overwhelming everyone’s minds will be gone,” said Jonathan Golub, chief U.S. equity strategist at Credit Suisse. “If we have a good quarter, the impediment that translates to stock market returns will be removed.”
There may be some more earnings pain before that. The effect of renewed lockdowns will be felt in results for the fourth quarter, a period that will again be compared to strong pre-Covid earnings from the year before, and yet expectations may be higher after the surprising earnings just announced.
“Frankly the main reason they’ve beaten expectations is that companies were modeling for zero revenues,” said Imran Sattar, fund manager at Majedie Asset Management Ltd. Lockdowns were not quite that devastating to the top line, so the bar to beat was low.
“Analysts are learning as they go” and remained too conservative for the third quarter, said Stephane Monier, chief investment officer at Banque Lombard Odier & Cie. They likely “won’t make the same mistake again.”
And there are clear limits to how much further companies can lower their spending, raising the question of how sustainable these “low-quality” beats, driven by declining costs instead of revenue growth, will be.
Take the auto sector. Carmakers Ford Motor Co. and BMW AG, truck manufacturer Volvo AB and parts supplier Continental AG did better than expected, largely because of lower sales expenses and reduced research and development spending, said Tom Narayan, an analyst at RBC Capital Markets. When volumes recover, those costs will return, he said.
“For a period, you can kind of try and control earnings because you can cut costs, but if your top line keeps falling, that really is a structural problem that’s quite hard to deal with,” said Paul Markham, head of global equities at Newton Investment Management in London. “The fourth quarter in terms of plain numbers could be quite bad.”
In some industries, though, Covid has forced a radical transformation, causing a number of shifts that had already been occurring to be condensed into a short space of time.
In retail, companies have been forced to accelerate their online and delivery capabilities and rethink their commitment to pricey bricks-and-mortar stores. For some, like Sweden’s Hennes & Mauritz AB and Spain’s Inditex SA, this accelerated focus on getting online businesses up to scratch has “cut out a lot of middle men” in the supply chain and will leave them healthier and more aligned with consumer behavior, said Saxo’s Garnry.
In the U.S., six of the 11 S&P 500 sectors managed to deliver positive earnings growth in the third quarter. In Europe, only the tech sector has done this, according to JPMorgan. Europe is lagging behind the rest of the world for upgrades to earnings estimates, according to Citigroup’s Earnings Revisions index.
The upward revisions to U.S. estimates “are moving to solidify a V recovery in 2021,” Bloomberg Intelligence strategists Gina Martin Adams and Wendy Soong said.
How much upside this points to for equity markets, however, is debatable. Price reaction during the European earnings season has been slightly negatively skewed, Morgan Stanley strategists said. This indicates that some of the relatively better news was already accounted for in stock prices.
“The market is pricing in moving on,” said Ben Ritchie, head of European equities at Aberdeen Standard Investments. Analysts predict a 40% earnings recovery in 2021, which is a “big number.”
Deciphering which sectors will be able to maintain low costs and higher margins, which are structural winners in a post-Covid world and which will be facing restructuring pressures for some time to come will likely be a defining feature of 2021. Overall, though, earnings are likely to be supportive of the market.
Third-quarter results are “helping markets shrug off cautious guidance and look forward to a resumption in 2021 earnings momentum,” Bloomberg Intelligence strategists Laurent Douillet and Tim Craighead wrote.
— With assistance by Lisa Pham, Morwenna Coniam, Ksenia Galouchko, Ishika Mookerjee, Moxy Ying, Abhishek Vishnoi, Michael Msika, Ryan Vlastelica, and Crystal Kim