What Earnings Reports Reveal About the Economic Toll of COVID-19

Jeff DeMaso:
Earnings are down 35%. That is a big, scary number. But when is negative 35% not that bad, maybe during the midst of a pandemic. Join me, Jeff DeMaso, as I talk with Kate Austin and Steve Johnson, two members our Dividend Income team to talk about earning season and put it into perspective. Hello, and welcome to another The Adviser You Can Talk To Podcast. I’m Jeff DeMaso, director of research here at Adviser Investments. And today I’m joined by Kate Austin and Steve Johnson, two members of our dividend income team. Kate, Steve, welcome to the podcast.

Kate Austin:
Thanks for having me.

Steve Johnson:
Great to be here today, Jeff.

Jeff DeMaso:
Yeah, I should probably say welcome back. You both are experienced podcasters at this point. So, let’s get straight into it. Kate, I know that we are smack in the middle of your favorite time of the quarter: Earnings season. This is when company managements host calls to tell analysts how they did in the prior three months. And usually to give us a sense of what they see coming down the road ahead. Nobody needs me to say it, but these aren’t normal times. It’s also not going to be a surprise to anyone to hear that companies earned less in the second quarter than they did in prior quarters. But Kate, can you maybe start us off with an overview and give me a sense of how earnings have been this quarter?

Kate Austin:
Yeah, so Jeff, unfortunately there’s really no way to slice it. Earnings this quarter as a whole have been pretty bad. About three-quarters of the S&P 500 have reported their quarterly earnings, and those earnings have contracted about 35% from their levels at the same time last year. And this is after an almost 15% contraction in the first quarter. Of course, this is because of the shutdown of the economy due to coronavirus. And really what we’ve seen through what we really talk of about here at AI, is the dimmer effect versus the light-switch effect.

Kate Austin:
At the beginning of the pandemic, everyone thought, okay, this is bad, but when we reopen everything will be flipped back on and it’ll be business as usual. If we were to have seen this, we would have had basically zero earnings for April, but then May and June things would come roaring back as the economies opened again. And this really couldn’t be further from the truth. We’ve seen a number of changes happen, capacity changes, social distancing measures, et cetera. But most importantly, the change that we’ve really seen is consumer behavior. A lot of people are very hesitant to return to their pre-COVID activities, which is why we have seen a much slower recovery and this huge dip in Q2 earnings.

Jeff DeMaso:
Yeah, Kate. I guess it’s no surprise that earnings have been bad. And we talked about that dimmer switch as opposed to just flipping the switch coming into the quarter. So, no surprise us. So, maybe Steve, what are the surprises from this earning season?

Steve Johnson:
Well, Jeff, I think one of the surprises is that analysts continue to get it wrong. That really has been a surprise to me. Coming into this quarter, we saw expectations by analysts were lowered significantly. And yet what we’ve seen is that 84% of the companies that have reported earnings have actually reported EPS or earnings above the estimates. And in fact, if this trend continues this week and next it’ll mark the highest percentage of S&P companies reporting a positive earning surprise, really, since we began tracking this metric in 2008. So, that’s been a surprise. The other big surprise is, and actually it’s what worries me down the road. What’s surprising is the number of companies that have issued positive guidance going forward. And so, it has been a small sample. There are 32 companies in the S&P which have issued guidance. Yet of those 32, 25 of them have actually issued positive earnings guidance going forward. And of those 25 companies, really nine of them have been in technology, four of them have been in health care, which really isn’t a surprise because those have been two of the best performing sectors this year.

Kate Austin:
But to that point, I mean, couldn’t you say too, that arguably the only companies that are willing to give guidance are those that would be sure almost, that they would be able to achieve that guidance.

Steve Johnson:
Yeah. Kate, I think that’s true. And I think it’s also providing us with confirmation of some of the trends that Jeff and you and Dan have all talked about for quite some time now, is that the companies that are doing well as they entered before the pandemic continued to do well. And those industries and those companies that have been impacted by the pandemic are clearly not doing well. And so, those companies that have cut their guidance, things like hotels, casinos, airlines, they will continue to suffer. And yet, as we’ve seen the technology names, as evidenced by Amazon and Apple, they continue to report extremely strong earnings and they’ve been able to raise their guidance going forward.

Kate Austin:
Well, that’s an interesting question, Jeff. I think this may give us a floor in terms of how bad things get, just because we really saw a lot of shelter-in-place orders around the world at different times. However, I do think it is highly unlikely that people will shelter in place again. I mean, of course, you can never say never, right? But I think that would really be a huge hurdle to clear, and things would have to get really, really bad. That being said, what I was speaking about before was, we don’t really know what the long-term changes are to human behavior and the knock on effects of those behavior changes. I was reading an article the other day saying that the global airline industry will not fully recover until 2024. Now that’s four years out, right?

Kate Austin:
A lot can happen between now and then. But it’s not that wild to think of that situation where four years down the road, everything has finally recovered. I mean, it’s easy to see now. No one is flying. People are scared. And when we look at something as widespread as flying pre-pandemic, it’s easy to look at all the ways that flying touches other areas of the economy, right? It’s not just tourism. It’s the stores at the airline terminals, those are all closed. The Uber, Lyft, cab rental, rental car businesses. It’s super hard to find an Uber or Lyft now, Hertz has gone bankrupt. No one’s driving. The list goes on and on. And I do think it’s a little bit of a chicken and an egg situation where businesses don’t want excess capacity, for example, flying a bunch of empty planes. But people want things to feel back to normal and feel comfortable before they recoup their normal behaviors. So, while we may have seen the worst of it, I think that dimmer light effect is going to be with us to stay for quite some time.

Jeff DeMaso:
Okay. So, we often say that earnings drive markets. But as you just described there, Kate, COVID is driving behavior and in turn corporate earnings. So, I’ll kick it to Steve first. So, maybe do you both have a thought about, what do we think about earnings and the road ahead and that idea that earnings drive markets?

Steve Johnson:
Well, Jeff, I think we better have a map to drive that road, because I think there either could be an accident or some heavy construction up ahead. And really this is what is concerning to me. So, as Kate mentioned, the CEOs had the benefit of a restart in the economy during the second quarter. So, clearly we saw the shutdown in the first quarter, we saw a huge decline in economic activity, and then even in the beginning of the second quarter. But as the economy opened up again in May and June, we saw the data recover. And as you and Dan have spoken about, many thought we were in a V-shaped recovery. Well, as we’ve seen recently, really that economic recovery has slowed down over the last couple of weeks.

Steve Johnson:
And as we listened to the conference calls, so, Kate and I listened to a dozen conference calls so far this quarter. And over the past month many CEOs were actually confident in their views of the recovery, which really doesn’t jibe well with the economic news that we’ve been receiving over the last couple of weeks. So, I think it’s questionable that the momentum that we’ve seen from the end of the second quarter, if that can be sustained going forward. And that really, I think, poses somewhat of a danger as we go forward, especially if the economic news continues to weaken.

Jeff DeMaso:
Okay. Steve, you’ve given me a few concerns, maybe summed up as corporations and CEOs might be a little too optimistic about the back half of the year, but do you have any hopes or positive thoughts on coming up?

Steve Johnson:
Well, Jeff, I tend to be the eternal optimist. So, I’m going to be positive I think going forward. Because I think what we’ve seen is the economic news, even though it’s worsened recently, we’ve seen the earnings and the forecast for earnings going forward have actually increased. And this could be a concern too, but analysts are raising estimates for companies for the third quarter. And actually this is the first time that analysts have done this since the first quarter of 2018. And so, I think that’s some optimistic attitudes out there on behalf of the analysts. But also I think the real question Jeff, is on valuation in the earnings. And so, right now, health care, technology, both sectors that we continue to like, they’re expected to have the highest earnings in revenue growth for the third quarter.

Steve Johnson:
And as we’ve seen, they are the best-performing sectors. So, if they continue to perform well, obviously we think the market can continue to do well. And there’s also the hope that with Congress passing another economic stimulus package here, that really, that provides that bridge until we get, as we’ve talked about, until we get a vaccine or a more sustainable treatment. That bridge could actually sustain earnings in Q3 and Q4. And to be honest with you, I think there’s this huge myth out there that the market is tremendously expensive. And think that’s debatable. Of course, we’ve got interest rates here, real rates are negative. But if we look at certain parts of the market, if we look at right now the forward price-to-earnings multiple for the S&P is about 22-times.

Steve Johnson:
Now, clearly this is above the five-year average. But if you break it down into sectors, we find out that health care is trading at about 15 times forward earnings, right in line with its five-year average. Utilities at about 17 to 18 times forward, right about in line with the five-year average, same could be said for staples. So, right now we’re looking at certain sectors, again, which are expensive, which makes sense. The consumer discretionary is very expensive because we’ve seen earnings decline there precipitously, but for the rest of the market, we’re not seeing huge overvaluation. So, I think that is another reason to be optimistic as we go forward here into the back half of the year.

Jeff DeMaso:
Steve, I’m glad in there you mentioned Congress and the bridge that they’ve tried to build over this recession. I think that’s an important point when it comes to earnings and the health of the consumer and businesses. Kate, have we heard any commentary from companies around the Fed, Congress, and if that were able to ramp up or if it were to turn the other way and become more of a trickle? Just any thoughts that the business community has given on the fiscal side of this recession and our response?

Kate Austin:
Jeff, it’s kind of funny. We haven’t heard companies say much about the Fed, I think a little bit after the great recession in ‘08/’09, people almost expected the Fed to come in and create that bridge that Steve was talking about. And we haven’t really heard anything from company management saying anything about it at all. That being said, we have had so much stimulus come into the financial system in the past few months. We really have been buoyed by this. I mean, trillions and trillions of dollars. And don’t get me wrong, I mean, this definitely… The Fed needed to step in and do something, because otherwise we would have had an absolute catastrophe. Whether or not this bridge is elongated, truncated or is here to stay remains to be seen.

Kate Austin:
But I think we have a president in the White House, politics aside, who would very much like to be re-elected. And I think he has made it clear that he will do pretty much everything he can to get re-elected. I think we have seen a little bit more restraint by Washington in the past couple of weeks with a stalemate on the current stimulus bill, the next one, to get Americans through the rest of the year. But remember, I think if the next stimulus stops fully or even is lessened, I think it’s too early to tell what’s going to happen. Because don’t forget, last week was the last week that the additional $600 of unemployment benefits stopped. This is the first week that we’ll see the ramifications of that. So, unfortunately, really, no one has seen that paycheck pinch yet, but that’s something to consider.

Kate Austin:
I think, maybe, it’ll make more people motivated to go to work. But again, that’s only if there are jobs that are available or already haven’t been filled. I think the bridge is definitely necessary and something that the Fed had to do to step in, but that being said so much money doesn’t come free. Right? So, at some point we will have to pay this back in some form or another. Steve, I mean, what do you think about this? I know you feel strongly about the Fed.

Steve Johnson:
Well, I think the Fed has done whatever they can at this point. And clearly, we are in the midst of a pandemic. And at that point, the Fed felt it was necessary to provide the liquidity for the market. And that liquidity has clearly helped. Again, we talked earlier about interest rates as well. Yesterday we saw the 10-year Treasury go to 0.51%. And so, borrowing costs for corporations are extremely low. We saw Google issue a 10-year bond at extraordinarily low level. So, it’s a great time for corporations. Clearly that is going to help earnings as well.

Steve Johnson:
As we talked about valuations, when interest rates are this low, we can sustain a higher valuation than we could if the 10 year were at 5% to 6%. So, I think the criticism around the Fed this time is a bit misplaced. Clearly there will be some ramifications down the road, but at this point, if Congress can work with the Fed and pass more stimulus to get people comfortable between now and the end of the year, to stave off worsening of this recession, I think that would be a real positive for the economy as well as the market.

Kate Austin:
Yeah.

Jeff DeMaso:
Steve, I’m glad you mentioned income. Because if we can bring this back to our portfolios, you and Kate both work on our dividend income team. where the idea is to buy high-quality U.S. companies that pay a growing dividend over time. Of course, the concern today with earnings falling and difficulties in different sectors of the market and companies going bankrupt, is just a concern around companies being forced to cut or suspend their dividends. I mean, Kate and Steve, what are you both seeing on this? What’s the team’s thoughts around stability of dividend income for investors?

Kate Austin:
Steve, you want to take it first?

Steve Johnson:
Well, sure. I mean, I think Jeff, one of the things that you have to be careful about in this environment, and we talked about earlier, is certain industries have been devastated, whether it be airlines, hotels, casinos. And so, what you’re looking for, and what we always look for in companies is really those battleship-balance sheets. Companies that are able to generate free cashflow year in and year out, that are almost recession-proof.

Steve Johnson:
And fortunately we’ve had a number of companies in the portfolio that have increased their dividend even during the pandemic, which we think bodes well going forward. So, there are companies out there, there are certain sectors that continue to generate a tremendous amount of free cash flow, those are the names that we want to focus on. And you want to avoid those companies that have been adversely impacted. For example, this week we saw Capital One Financial, which is a lender credit card company, slashed their dividend from 40 cents to 10 cents. Clearly, that is a company that has been impacted by this, the consumer has been adversely impacted. And so, they’re not able to sustain that dividend. We are trying to avoid companies like that, that may see their business impacted not only in the next quarter, but going out a year or two.

Kate Austin:
Yeah. I would totally agree, Steve. I think making sure that we’re invested in companies that can do well, really, no matter what the economy is doing, is really what we strive to do. Companies with a strong, competitive advantage, or a cost advantage that will tend to outperform no matter what the environment, that’s really what we like to look at. The only other thing I would really say, is this earning season has been a little alarming. I mean, these are some scary numbers that we’ve seen in Q1, as well as Q2. No one knows what the future may hold. But I think there are some positive trends also that we’ve been seeing. I know I’ve talked about this before, and I know Steve touched upon this earlier in the podcast, but I think it bears repeating. I think the biggest change that we’ve seen is a lot of trends prior to COVID-19 have really been accelerated. Things that help not only technology but the consumer as well.

Kate Austin:
I was listening to a conference call the other day, and they were talking about the number of telehealth visits has skyrocketed. Obviously, because nobody wants to go into the doctor’s office or the hospital right now. And the number of emergency room visits has fallen by 50%. I mean, these are trends that I find very interesting, but also helps the economy and helps these sectors as a whole. I think we’ve seen a lot of like migration to the cloud, digitization of industries that probably didn’t have much digitization before. I mean, you think about some of these big industrial companies, they’re all trying to get onto the cloud. They’re all trying to boost their earnings with technology. And this work-from-home environment where everyone is remote, I think has just really accelerated that rate of change.

Kate Austin:
And we’ve seen that with the health care and technology sectors outperforming. But I think this does give the entire S&P 500 a little bit of the saying that, “The tide that rises all boats.” These changes are really going to help everyone moving forward. That being said, if you weren’t well-capitalized going into this, you might find that a little bit more difficult. But those that are well-capitalized can really take advantage of this situation. So, I know we’ve been talking about things that maybe aren’t the nicest things to talk about in this earning season, but there are really some really strong, positive tailwinds that should help propel us going forward.

Jeff DeMaso:
Great, Kate and Steve let’s wrap up here. You two have covered a lot of ground today. If I was going to try and sum up, there’s really two themes that stuck out to mind. One is, Kate, as you just mentioned, a lot of the trends that we saw before the virus came and we shut down economies has only accelerated. And then the other one is where we started to introduce a different metaphor than the light switch. The economy took the elevator on the way down and we’re now trying to climb the stairs back up, and it’s going to be a long, difficult climb, but we’re going to do it.

Jeff DeMaso:
And as we go along, certain companies are going to thrive on this climb and they’re going to come out stronger than they were before. So again, Kate and Steve, thank you very much. This has been Jeff DeMaso, Kate Austin, and Steve Johnson from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcast. Your feedback really is always welcome. If you have any questions or topics you’d like us to explore, please email us at info@adviserinvestments.com. Once again, I’d like to thank Kailey Steele, our editor and producer, for making this podcast a reality. And thank you for listening.