TwentyFour Asset Management
Last week we discussed the surprisingly resilient sentiment that has come out of the banking sector in recent months ahead of the start of Q2 earnings season, with Wells Fargo, Citibank and JP Morgan due to kick off an eagerly anticipated run of results on July 14.
We thought it was also worth commenting, therefore, on our expectations around non-bank earnings in what is likely to be the cyclical low for many companies. Indeed, the consensus on Q2 earnings for constituents of the European Stoxx 600 equity index is for a fall of 55% year-on-year. Given this backdrop, for bond investors the key question is to what extent current spreads reflect an extraordinarily weak Q2. Will we see a pullback if full-year 2020 forecasts have to be reassessed, or is there more room for spread tightening if companies outperform expectations for the quarter?
Before we dive into Q2 earnings, let’s look at what spreads have done since Q1. The Xover index (a proxy for European high yield credit risk) tightened from around 580bp on April 1 to around 380bp at the end of June. That move tighter has left us within 200bp of the January tights, with many names already back to levels they last saw at the beginning of the year. From a total return perspective the European High Yield Index returned 11.2% in the second quarter, after a staggering 14.6% decline in Q1.
Much of this retracement is a function of the extraordinary monetary and fiscal support from central banks and governments in recent months, but there is also an element of an evolving COVID-19 environment offering much more clarity in Q2 than it did towards the end of Q1. In addition, the near future looks better as economies have started reopening and activity has bounced back strongly. Given the severity of Q2 earnings declines, we expect Q3 and Q4 to show significant improvements, something that we are already seeing in some names with APAC exposure. Indeed, many of the large auto manufacturers have guided to Q2 China sales, with both Mercedes-Benz and BMW seeing double-digit sales gains vs. Q2 2019 (and that was in a quarter that saw various local lockdowns throughout China).
With respect to Q2 numbers specifically, we expect headlines to be bad, but for the market reaction to be muted to positive on outperformance of exceedingly low expectations. Put differently, we believe the probability that firms underperform Q2 expectations is low given how well-flagged they have been in recent months, both in the press and from the more forthcoming management teams. Indeed, investors were able to get very specific guidance during first quarter earnings calls on how Q2 had started, and given April was the worst of the lockdown for much of Europe, this has helped us model the lows with a fair amount of accuracy.
Ultimately, while Q2 will be a bad quarter for many companies even if they outperform expectations, in our view it is not the real driver of spreads at this stage. This continues to be virus uncertainty as economies open up, and the extraordinary amount of monetary stimulus that has been injected into the system. While central bank action is providing enough support for spreads in the face of more negative virus news (primarily out of the US), we continue to remain cautious on low rated, cyclical names that we feel would be vulnerable to further lockdowns. We prefer instead those companies that are better protected from an earnings perspective, and those that generate strong free cash flow with a conservative balance sheet. In more cyclical industries we think exposure should be limited to issuers well into the IG category.