Corporate Earnings Outlook: Why Are Expectations so Low?Learn more about this firm
By Tom West, Director of Equity Research, Columbia Threadneedle Investments
- Corporate earnings results for the second calendar quarter are likely to be a bit soft.
- Despite relatively high valuations, investors seem willing to accept that better results are shimmering out in the future.
- Near term, I would be more worried about stocks if earnings expectations were higher. Longer term, it also worries me that expectations are not higher.
Corporate reporting for the second calendar quarter started last week with a lead group of early reporters. Looking forward to the body of earnings season, I think results are likely to be, on average, a bit soft. And despite valuations that are on the high side relative to history, it just doesn’t seem that expectations are that high. In many industries, investors seem willing to accept that better results are shimmering out in the future, provided management teams can make a good case for what they are doing to position the company for that future. It is as if low interest rates have not only raised asset prices, but also made investors more patient.
In the information technology sector, the second quarter is usually stronger than the first, but channel checks of sales to enterprise customers have been on the weak side. A common longer-range theme is the transition from “on premise” software to software-as-a-service (SaaS). SaaS is more easily updated because it resides in “the cloud,” which can facilitate updates, maintenance and access, as well as provide other benefits. If big software providers like Intuit, Adobe, Autodesk, Oracle and Microsoft show progress moving their products to the cloud, investors may be more tolerant of low growth in the near term. As usual, companies in high growth areas like security software will have to track growth expectations. Meanwhile, China Internet companies will need to reassure investors that declines in the Chinese stock market don’t spill over into actual weakness in the overall economy.
An even starker transition phase is going on in the energy sector. With the collapse in global oil prices that started last fall, the sector has been in a period of adjustment. Energy analysts like to say that “low oil prices are the cure for low oil prices.” In the simple version of that maxim, oil prices drop, causing the more expensive supply sources to shutter, reducing overall supply. Prices rise and all is well. But cost structures are neither as simple nor as fixed as we may assume. So this will be another quarter where current performance is something of a footnote, while larger, longer-dated issues will be at the fore: Is production actually falling? How are management teams thinking about capital allocation? Have activity and pricing bottomed in energy services? And so on. In particular, it does seem as though costs have come down more than expected, which would tend to keep production higher and oil prices lower for longer.
The next round of quarterly conference calls will also give us a chance to take stock of the shadow the energy sector has cast on industrial stocks. Many industrial companies have had to come out with downward revisions to financial projections because the energy sector has greatly reduced the amount of goods and services purchased from industrial companies. In many cases, inventory destocking is compounding this slowdown. Also, the phrase “global capex pause” is circulating in the industrial sector. Add in slowing auto sales in China, and it is not surprising that investors are very eager to hear management teams discuss order trends and the general business outlook. Industrial stocks have underperformed the broader market by about 5% this year, but it’s not clear that expectations have hit bottom.
I would have thought the heightened macroeconomic jitters and slight steepening of the yield curve would be more of a benefit for the large capital market players. One of our senior financial analysts cautioned me on that upbeat interpretation, and so far the reports are lining up with the analyst (which I find reassuring). The “Grexit” saga seems to have caused investors to stay on the sidelines more than it induced them to go out and buy insurance via various derivative contracts with investment banks. The steepening of the yield curve, while in the right direction, has not had a chance to have much impact on net interest margins. On the bright side, all the M&A activity we have been seeing in the news did translate into a nice increase in business for investment banks facilitating the recent torrent of deals.
In the near term, I would be more worried about stocks if expectations were higher. But, longer term, it also worries me that expectations are not higher.