Global Weekly Commentary: Focusing on factors
Trough in corporate earnings
A trough in corporate earnings supports our decision to close an underweight in cyclical equity exposure such as value. We prefer quality for its resilience.
Negotiations over the size and makeup of a new U.S. fiscal package are intensifying as key benefits expire and states face budget shortfalls.
U.S. employment figures are in focus this week as this fiscal cliff nears and the pandemic’s spread in Sunbelt states is starting to affect economic activity.
Corporate earnings estimates look to be troughing as economies reopen with fits and starts. We have increased our overweight in the quality factor because we see it as most resilient to the dynamics of a choppy activity restart, given its focus on companies with strong balance sheets and profitability. We also recently closed our underweight in cyclical assets, including upgrading the value factor to neutral.
Chart of the week
Corporate earnings revisions across regions, 2007-2020
Source: BlackRock Investment Institute, with data from Refinitiv Datastream, July 2020. Notes: The chart shows the three-month change in equity earnings revisions across regions. Earnings revisions are defined as the number of forward earnings estimate upgrades minus the number of estimate downgrades, expressed as a percentage of the total number of forward earnings estimates. Indexes used: MSCI USA, MSCI EMU, MSCI Japan and MSCI Emerging Markets.
The coronavirus shock dealt a historic shock to the real economy – and the biggest blow to corporate earnings since the 2008 financial crisis. Yet earnings revisions – or the ratio of upgrades to downgrades of corporate earnings estimates by analysts – look to have troughed in recent weeks. This is true across major regions, including emerging markets, as the chart above shows. Even the euro area (yellow line) – which saw the deepest trough – looks to have bottomed. The activity restart – one of the three key investment themes we explored in our Midyear Outlook – is a key reason for the increased optimism on the path of corporate earnings. To be sure, we expect this restart to be uneven over time and across regions. We see Europe as the most attractive exposure to a multi-speed global restart, as detailed in Favoring euro stocks in global restart.
U.S. corporate earnings season is in full swing, with more than half of S&P 500 companies having delivered second-quarter scorecards. Roughly 80% of firms have beaten profit estimates, which had been slashed around 30% since January. Most sectors are seeing profits fall relative to a year ago, with energy earnings hardest hit. The tech and utilities sectors look on pace to register year-on-year earnings gains. Similar earnings trends are showing up in Europe and elsewhere. While the earnings cycle appears to have troughed, we believe consensus expectations for a return to 2019-level earnings next year may be overoptimistic. This points to downside risks if the activity restart is delayed – and policy stimulus fails to bridge households and businesses through the income shock. When assessing the impact of the shock on the economy, we focus on the cumulative GDP loss over time – or economic shortfall. Likewise, equity prices should reflect not just the near-term earnings outlook but the cumulative earnings loss versus the pre-virus trend. We expect this recovery to take several years.
Against this backdrop, we have increased the magnitude of our overweight in quality. We see quality companies – those with strong balance sheets, profitability and free cash flow – as those most resilient against the uncertainties in a multi-speed global economic restart. In addition, the factor includes many of the best-positioned companies in sectors such as tech, communication services and healthcare that are benefiting from secular growth trends that look to have been accelerated by the pandemic (think work from home). Many of these companies are found in the U.S. Yet we recently downgraded U.S. equities to neutral. Why? We previously preferred the U.S. for its strong policy response and quality bias. We still like the quality parts of the U.S. market, but have become more cautious overall due to a challenged public health backdrop and a risk of reduced fiscal policy support as key relief measures expire. This leads us to be increasingly cautious on broad U.S. exposures outside of those core quality holdings.
The differentiated global restart has also led us to close an underweight in cyclicality. This is reflected in our recent upgrade of the value factor to neutral – and a downgrade of min-vol to neutral. On a regional basis, we upgraded European equities to overweight and Japan to neutral from underweight, as we see these regions offering exposure to a cyclical uptick. Europe’s strengthened policy framework is another positive. What about momentum? The factor has outperformed in 2020 to date, but we stay neutral given that the fits-and-starts economic restart may challenge trending exposures.
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