The earnings recession will likely continue with second quarter results, which will begin with a small handful of companies reporting this week (July 5–8, 2016). The Thomson-tracked consensus estimate for S&P 500 earnings per share (EPS) is calling for a 4% year-over-year drop, which would mark the fourth consecutive quarterly decline (by FactSet’s count the streak would reach five). Perhaps the best thing to say about this streak, the longest since 2008, is that the drop will likely confirm that the 5% year-over-year decline in the first quarter of 2016 marked a trough.
But signs are pointing to better times ahead. U.S. economic growth has picked up in the second quarter of 2016 based on available economic data. Despite the U.S. dollar rally following the Brexit news on June 23, 2016, we expect the dollar to turn from a headwind to tailwind in the second quarter of 2016. Higher oil prices should lead to a smaller (but still large) decline in energy sector profits. And we do not expect the Brexit news to have a meaningful impact on results.
This week we preview the upcoming earnings season and update our thinking on the prospects for an earnings rebound in the second half of 2016.
BETTER U.S. ECONOMIC PICTURE
U.S. corporate profits are closely tied to manufacturing activity and capital spending. Accordingly, earnings have historically been well correlated with the Institute for Supply Management’s (ISM) Manufacturing Index, a survey of purchasing managers’ future spending plans. As a result, the strong and better than expected ISM Index of 53.2 for June (reported July 1), the fourth straight reading above 50 and second straight month of improvement, is a positive signal [Figure 1].
We expect another bounce back in second quarter gross domestic product (GDP), to perhaps 3.0% or more, despite the weak May 2016 jobs report and weakness in Europe, and see capital spending beginning to pick up following the nearly two-year oil-driven slump, despite heightened political uncertainty.
FADING DRAG #1: U.S. DOLLAR
We expect the earnings drag on foreign profits from a stronger U.S. dollar to dissipate during the second quarter of 2016 despite the latest Brexit-driven rally. Even with the 3% jump since the Brexit news on June 23, 2016, the dollar has weakened considerably since December 2015, as expectations for Federal Reserve (Fed) rate hikes in 2016 have been pared back—to the point where no hikes are being fully priced into federal funds futures markets in 2016 or 2017. The average dollar index level in the second quarter of 2016 was 1.7% below that of the same quarter a year ago, providing a tailwind for earnings. And should the dollar remain where it is for the rest of 2016, currency would be a tailwind for the second half of the year as well, after representing a drag of as much as 20% on foreign profits during the second quarter of 2015
FADING DRAG #2: OIL
The drag on earnings from the energy downturn has been even bigger than the dollar drag over recent quarters. The sector posted a small loss in the first quarter of 2016, registering a 105.7% year-over-year earnings decline, which trimmed about 5 percentage points off of overall S&P 500 profits. Low oil prices will still likely lead to energy sector profit declines in the second and third quarters of 2016 based on consensus estimates. Oil prices averaged 21% less in the second quarter of 2016 than in the second quarter of 2015. However, should oil prices stay at current levels, the commodity would show a year-over-year price gain in the third quarter of 2016 [Figure 3] and position the sector to potentially produce double-digit earnings gains in the fourth quarter.
Broadly, we expect Brexit to have limited impact on earnings. S&P 500 companies overall have minimal exposure to the U.K. (estimated less than 5%, according to FactSet). Although some companies will surely use Brexit as an excuse for falling short of estimates, overall, we do not expect political and economic uncertainty in the U.K. to have much impact on U.S. company profits.
Brexit has had some negative impact on corporate profits through the stronger dollar and tighter financial conditions. The financials sector is perhaps most impacted given its sensitivity to interest rates, which remain near post-Great Recession lows; the 10-year Treasury yield closed at 1.46% on July 1 and dipped below 1.40% intra-day on July 5. One way Brexit has not yet negatively impacted earnings is commodity prices; the Bloomberg Commodity Index is actually up since the Brexit news despite dollar strength.