As we enter Q2 earnings season, we will be most interested to learn how Corporate America has fared over the past three months.
Kicking off with bank earnings on Tuesday, we saw JP Morgan and Citi beat expectations led by revenues from their investment banking divisions. Wells Fargo could not deliver the same and was the outlier, reporting its first quarterly loss since the financial crisis. Interestingly, all three banks added significantly to their credit reserves due to uncertainty regarding the future path of the economy.
During the Q&A segment of their respective earnings calls, the questions centred around this increase in credit loss provisions, future charge-offs, loan delinquencies and forbearance measures, as investors and analysts sought to gain a better understanding of further loss provisions that may be on the horizon.
Apart from the increase in reserves, one common thread was consistent throughout. Each bank had a base case economic scenario and provisioned accordingly given its economic projections. JP Morgan’s CEO, Jamie Dimon, even suggested that his bank may have provisioned conservatively. Despite some recent positive macroeconomic data and significant, decisive government action, we still face uncertainty regarding the future path of the US economy.
So given this blurry outlook, what can we expect from upcoming corporate earnings in the US and looking ahead to Q3? The outlook for corporate earnings appears just as uncertain.
Some of the near term catalysts that could improve the outlook would include the following:
Negotiations on the next fiscal support bill are due to begin when Congress reconvenes next week. Expectations are for a package that surpasses $1 trillion, and not only extends provisions found under the CARES Act but could also include provisions supporting an Infrastructure Bill.
Q2 earnings could surprise to the upside. Given the consensus forecast is for S&P 500 earnings to decline by 44%, the bar is set pretty low and surprises to the upside would provide support to the marketplace. We are not expecting to hear much forward guidance from firms, but we do think we could see upside surprises, particularly in those industries that have benefited from the early stages of reopening.
Given that we are likely to be in this low rate environment for the foreseeable future, investors will look to the credit markets for incremental yield to target more attractive returns. We have seen 14 consecutive weeks of inflows for investment grade funds, extending inflows to over $146 billion since March. High yield has not been left behind, attracting just over $55 billion in the same timeframe. As a result, the market continues to be well supported as investors chase yield.
Some portion of these inflows can be attributed to investors’ rotation out of low yielding government bond markets into credit. As we have said for some time now, while government bonds are termed ‘risk-free’ the majority of them are now probably ‘return-free’ as well. Add that to the asset class yielding negative rates globally, and flows to credit should continue to benefit.
Recent data has been encouraging; June payrolls, May housing, personal spending and retail sales data have all shown improvement.
We expect a slowdown in new issuance for the second half of the year. With IG issuance year-to-date already running at 100% of 2019 levels and HY not far behind at 60%, many issuers have already established protective cash buffers to withstand the current economic slowdown. As such, it seems very unlikely that we will reach similar levels of supply for the remainder of the year, unless there is a crippling second wave of the virus.
Finally – and probably most importantly – the massive technical support provided by the Fed is unlikely to falter any time soon. Jerome Powell has committed the Fed to using its tools to do whatever it can, and for as long as it takes, to ensure the recovery will be as strong as possible. This has given investors the confidence to invest in record numbers, and the Fed has only scratched the surface of its recent SMCCF programmes, which has also provided a strong backdrop for credit spreads to continue their recovery towards pre-COVID levels.
As we mentioned in a previous blog, we see continued strength in credit markets and a slow grind tighter in spreads. We will look for the remainder of the Q2 earnings season to shed more light on the trajectory the recovery will take.