Broker Check

A Two Year Earnings Recession?

October 19, 2020

As the economy continues to recover from the pandemic, it's likely that corporate profits will follow suit. The stock market, after all, has not only fully recovered but has reached new highs in anticipation of an economic rebound. How long this process takes and whether there are hiccups along the way will depend on many factors such as the ongoing public health response, the return of business and consumer demand, the health of financial markets, as well as short-term uncertainty around the presidential election. What can investors expect of corporate earnings in the year ahead?

At the moment, many economists expect GDP growth in the third quarter, which will be reported in a couple weeks, to have exceeded 30% on an annualized basis. This would be an extraordinary bounce after economic growth collapsed by 31.4% in the second quarter (note that due to the way growth rates work, a 45% increase is required to recover from this decline). In general, a full recovery isn't expected to take place until the end of 2021 for both the economy and earnings, representing about two lost years of growth.

This is because while more than half of the jobs lost during the early months of the COVID-19 crisis have returned, these were most likely in areas of the economy that could recover quickly - if they were affected at all. The second half of this recovery could take much longer and be more difficult, especially in areas still affected by shutdowns and social distancing such as in-store retail, dining, travel and hospitality. 

Of course, investors don't invest in the economy directly. Instead, when the economy heals, investors benefit as companies see improved financials which support stock prices. While current estimates suggest that full-year 2020 earnings will fall by almost 20%, they are then expected to rebound by 26% in 2021 for a full recovery. Some sectors have already seen earnings boosts due to the acceleration of digital transformation, the spending of stimulus checks, and more. Over the next twelve months, Wall Street estimates are for a 17% growth in S&P 500 earnings-per-share. The fact that the stock market is always forward-looking is one reason for the rally of the past six months. 

This pattern is not unique to the U.S. stock market but can be seen across major regions. Developed markets, driven by Europe, are expecting earnings to grow by 22%. Emerging markets expect similar growth of 24%. Globally, public companies are expected to grow their earnings-per-share by almost 19%. Again, whether this comes to fruition will depend on many factors with the public health response to COVID-19 being the most important. Overall, these other regions are still more cheaply valued than the U.S.

An important component of the domestic economic rebound has been the CARES Act and other government support measures. While their true impact may not be known for some time, it's likely that stimulus checks and the Paycheck Protection Program helped to boost confidence and keep consumers and businesses on life support. This was especially important in March and April when the nationwide shutdown was occurring.

The flip side of this spending has been the massive growth of the federal deficit. For the fiscal year which ended in September, the deficit ballooned to $3.1 trillion from about $1 trillion in 2019. While the deficit and national debt are sources of long-term concern for many investors, it's understandable that they are a direct result of emergency pandemic spending.

Ultimately, investors should continue to focus on corporate earnings and valuations since, in the long run, they are what drive stock market returns. While this was difficult if not impossible to do during the height of the crisis earlier this year, there are many signs that the recovery can continue through 2021. Although there are still many uncertainties, history shows that those who are able to stay invested when times are tough can often improve their odds of financial success.

Below are three charts that highlight the uncertain recovery in earnings ahead.

1. Corporate earnings have fallen alongside the economy this year

Corporate earnings have fallen significantly in 2020. Current estimates suggest that earnings growth will decline by 19% during the full calendar year. However, like the economy, profits are expected to rebound in 2021 and beyond. Thus, an important component of the stock market recovery has been an expectation that corporate earnings will stabilize.

2. The earnings recovery is expected to occur worldwide

This earnings recovery isn't expected to occur only in the U.S. but will likely happen worldwide. This clearly will depend on many factors related to COVID-19. However, many sectors and businesses are already seeing improved demand and have even increased hiring over the past six months. 

3. Government spending to support the economy has blown out the deficit

The flip side of government spending through stimulus checks, the Paycheck Protection Program and more has been the ballooning federal deficit. It's possible that the deficit will surpass 15% of GDP for fiscal year 2020, which ended in September. While it's clear that deficits tend to rise during times of economic crisis and war, it could also take years for federal spending to return to more normal levels as the pandemic continues.

The bottom line? The stock market is already anticipating a multi-year recovery in corporate earnings. This will likely help support stock market valuations and price levels in the year ahead. Long-term investors should continue focusing on these fundamentals while staying invested.

Click Here To Read More Blog Posts >>