Earnings Season Hides in the Government Shadow

Markets Climb on Non-Default

Equity markets posted their best weekly gain in three months, sparked by a resolution by Congress that restored the government and lifted the debt ceiling, avoiding default. Markets climbed every day but Tuesday, as investors largely anticipated the resolution. For the week, the S&P 500 rose 2.44%, while the Dow Jones Industrial Average gained 1.12%. Some of the discrepancy between the two indices was due to Dow component IBM, which shed almost 7% last week after missing revenue estimates by more than $1 billion.

Despite a ramp up in corporate earnings season, the government shutdown dominated headlines last week. Congressional leaders pushed up against the October 17 deadline imposed by the Treasury Department, before the Senate and House reached a deal. The chambers approved the measure late Wednesday night, with President Obama signing it into law early Thursday morning.

The passed measure included little of the modifications to the Affordable Care Act or entitlement spending that Republicans sought. Instead, a short-term deal was reached which sets the stage for another conflict as soon as January 15, when funding for the government will run out. The debt ceiling was suspended until February 7.

Given the government shutdown, economic data was once again limited last week. Perhaps the most important release was Wednesday’s Beige Book, which is a compendium of economic activity across the country compiled by the Federal Reserve. Many consider this report to have strong influence over the Fed’s view of general economic conditions.

October’s Beige Book reported that economic activity “continued to expand at a modest to moderate pace” during the evaluation period. That is the same characterization used for the last several reports, which is a downgrade from the “moderate pace” described in April. In the most recent edition, it was noted that four of the twelve reporting districts experienced slowing growth. This is a deterioration from recent Beige Books in which most districts were expanding.

This backdrop is a key variable as we near a scheduled Federal Open Market Committee (FOMC) meeting on October 29-30. Markets’ attention will soon shift to this meeting and to whether the Fed will initiate a reduction in its current level of quantitative easing. Mixed signals by the Fed, and the recent nomination of Janet Yellen to head up the bank, make it unclear as to what decision the group will make. Further reports of economic softness like that contained in the Beige Book will likely slow the Fed’s enthusiasm for such steps.

Other Federal Reserve data was released in the form of regional manufacturing reports last week. This included the Empire State Manufacturing Survey and the Philadelphia Fed Business Conditions Index. Both softened in October, but remain in positive territory, suggesting expansion despite the government shutdown.

Earnings season hides in the government shadow

Lost in all the discussion about Washington is the fact earnings season is in full swing. It is shaping up to be another interesting reporting season, on account of volatility in the markets and economy. So far, companies are beating expectations, but the broader trend is lower.

Over the course of the third quarter, analysts reduced third quarter earnings per share (EPS) estimates for the S&P 500 index by 3% to $26.55. Since the start of reporting season, though, third quarter EPS estimates are up 0.5% to $26.68. There are signs that the fourth quarter could be similar, with fourth quarter estimates falling consistently since earlier this year. Fourth quarter estimates now stand at $28.49.

Source: Goldman Sachs

Of the 97 companies that released earnings to this point, 69% reported above mean EPS estimates and 31% are reporting below the mean estimate. These numbers should be considered in the context of lower analyst expectations, making them relatively easier to beat. That said, several sectors are performing especially well to this point – telecom, technology, energy, consumer discretionary and materials.

While analysts are proactively reducing fourth quarter estimates, companies are mostly reserving judgment for the time being. There are 14 companies that reported negative EPS guidance and 4 offering positive EPS guidance. By most expectations, analysts will continue to revise fourth quarter estimates down.

A host of issues could affect the next few months, but corporate executives appear somewhat concerned about the impact of the government shutdown on their bottom line. FactSet published comments from several earnings releases that cited the shutdown as cause for lower forward earnings. Linear Technology, for instance, said, “We’ll have some impact from the budgetary stalemate.”

One industry that is struggling at present is banks. According to the Wall Street Journal, the ten largest commercial banks so far reported earnings that are down 6.9%. Citigroup summarized the situation best by saying, “our results reflect the challenging operating environment, including a slowdown in client activity based on uncertainty regarding Fed tapering, concerns about the effect of the U.S. government shutdown and forecast for slowing economic growth, particularly in emerging markets.” Rising interest rates are on net a tailwind for banks, but the sudden increase seen this year is dampening demand for mortgages, while also driving down trading activity in fixed income markets.

Source: Wall Street Journal

The upcoming week will be the busiest thus far as 146 companies from the S&P 500 index are scheduled to report. Companies to keep an eye on include McDonald’s, Lockheed Martin, Boeing, AT&T, 3M, Ford, Amazon.com, and Microsoft.

Early analysis of this quarter’s earnings suggests another modestly positive quarter. The trend to watch may be fourth quarter expectations, which are already moving lower and may continue to do so. Companies are facing lower growth expectations in emerging markets, along with volatility in the domestic economy. Despite being overshadowed by the latest showdown in Washington, investors should not ignore the ongoing earnings season.

The week ahead

A deluge of economic data is expected to hit over the next two weeks, now that the government has been reopened. This week’s slate includes the employment report on Tuesday, existing home sales on Monday, and durable goods on Friday.

Look for increased Fed talk on the other side of this data, particularly the jobs report, with the next FOMC meeting less than 10 days away.

Central banks meeting this week include Turkey, Canada, Sweden, Norway, Philippines, Colombia, and Mexico. Minutes from the most recent Bank of England meeting will be released on Wednesday.

The information provided is general in nature and is not intended to be, and should not be construed as, investment, legal or tax advice. Fortigent makes no warranties with regard to the information or results obtained by its use and disclaims any liability arising out of your use of, or reliance on, the information. The information is subject to change and, although based upon information that Fortigent considers reliable, is not guaranteed as to accuracy or completeness.

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