- This article provides a list of companies whose earnings will be affected by the BREXIT.
- The dollar is stable thus we should not expect strong global currency effects.
- The probability of U.S. recession has hit an 8-year high which should be detrimental for earnings in next two years.
In the long term, stock returns are perfectly correlated with the underlying earnings and therefore the upcoming Q2 2016 earnings season is very important. Positive earnings could push the markets to new highs while bad news could indicate the start of a recession or bear market.
In this article we are going to discuss how to prepare yourself by analyzing various factors that influence earnings.
Factors That Will Influence Earnings
To come to the best possible estimations, we are going to analyze commodity prices, currency swap rates and general economic trends.
As more than 30% of S&P 500 revenues comes from abroad, currency translation effects are very important to analyze, especially now after the BREXIT.
Figure 1: USD per 1 GBP in last 12 months. Source: XE.
The British pound has fallen 10% in relation to the dollar which means that all the assets, revenues and profits from the UK are now 10% lower than they were two weeks ago. This is the reality, but then there is accounting that will try to tell you various stories.
The impact on earnings will depend on the way a company accounts for its overseas assets and revenues. Companies that use the current rate method (i.e. the rate on the last date of the financial statement) will be immediately affected, while companies that use the temporal method (i.e. the historical rate at the date assets were bought) will not show the complete impact of the BREXIT in their statements.
Companies that get more than 15% of their revenues from the UK are Molson Coors (NYSE: TAP), BlackRock (NYSE: BLK), and eBay (NASDAQ: EBAY). Other companies that are also exposed are Apache Corporation (NYSE: APA), Transocean (NYSE: RIG) and ConocoPhillips (NYSE: COP) in the oil sector, and Invesco (NYSE: IVZ), E*Trade (NASDAQ: ETFC), Morgan Stanley (NYSE: MS) and Citigroup (NYSE: C) from the financial sector. Investors with those companies in their portfolio may want to check the accounting policies so they won’t be surprised by bad news in the upcoming financial reports.
All in all, the dollar index was even a bit weaker than in Q1 2016 and equal to its Q2 2016 level, so investors shouldn’t be worried about currency issues, with the exception of the UK exposed companies listed above.
Figure 2: U.S. dollar index. Source: Bloomberg.
Average oil prices in Q2 2015 were around $60 per barrel while average oil prices in April 2016 were $37.86, May $43.21 and June $50, which is an average price of $43.69.
Figure 3: Average monthly oil prices. Source: Statista.
No matter the story presented by companies, trailing earnings will be severely hit and year-on-year comparisons will be negative as the price of the product they are selling is 28% lower than in Q2 2015. Long term investors should not be fooled by the growth in relation to Q1 2016 as oil prices are 50% higher, but traders can seize short term opportunities given by the positive short term trend.
Gold stocks should see a nice boost to their earnings as gold prices have surged since March. Iron ore miners should also have positive news as iron prices were in the $55 to $60 trading range compared to the $40 to $45 in the two previous quarters. The same holds for copper, zinc and nickel prices.
In the fertilizer sector, prices continue to be around historic lows so investors should not expect a rebound. Ammonia prices are reaching new lows, and urea prices are at multi-year lows. The same is true for UAN prices and potash, but things might change in the next quarter as Canadian potash producers started to cut back on production.
General Earnings Trend
The general earnings scorecard doesn’t look that good. S&P 500 earnings are expected to decline by 5.3%, and this decline will mark the fifth consecutive earnings decline.
Figure 4: Earnings and S&P 500. Source: FACTSET.
As earnings have stopped growing, the S&P 500 has also stopped growing which only reinforces the theory that in the long term, stock returns are perfectly correlated to underlying earnings.
The 5-quarter decline in earnings growth suggests companies have reached their earnings limit in the normal economic cycle with low interest rates keeping asset prices high. In such an environment, bad earnings surprises are not uncommon and could have a negative impact on the market. Of the S&P 500 companies that issue guidance, 81 have issued negative guidance for Q2 2016 and only 32 positive EPS guidance.
The Economy and Longer Term Earnings Perspective (One Year)
The declining earnings indicate that companies have reached their earnings limit due to fierce competition. The artificial environment created by low interest rates makes everybody succeed and brings down margins. Even though no one likes it, a recession would be great as it would root out the weeds. According to Deutsche Bank, the probability of a recession in the U.S. in the next 12 months has hit highs not seen since 2008.
Figure 5: Probability of U.S. recession in the next 12 months. Source: Deutsche Bank.
As earnings have been declining for 5 quarters, it is logical that investments will be lower which is exactly what is happening.
Figure 6: Domestic business investments. Source: St. Louis FED.
Lower business investments should keep up earnings for a while but are detrimental to earnings in the long term.
The picture is pretty clear. Investors should focus on the geographical market of their respective investments and try to assess currency impacts before earnings are disclosed, especially for UK exposed companies.
In the long term, the high probability of a U.S. recession combined with 5 quarters of declining earnings indicates that the risks are higher than the rewards and investors should position themselves accordingly in the next two years.