The future’s uncertain and the end is always near.
-The Doors, Roadhouse Blues
The second quarter of 2020 was one of the ugliest quarters in US Economic history. Most lockdowns related to the Covid-19 outbreak did not take effect until late March. Consequently Q2 is bearing the brunt of the economic impact. It’s no surprise that there have been record high cuts to earnings forecasts. How bad will earnings be? It turns out the companies themselves don’t know.
Analysts have been forced to make forecasts with less help from company management. According to FactSet, 54% fewer companies are issuing earnings guidance for 2020Q2 than before. An even larger group of companies have suspended full year earnings guidance. According to IR Magazine, at least 341 companies suspended annual guidance between March 16, and April 12 alone. Analysts have been repeatedly adjusting their forecasts with new information on Covid-19 , and the societal reaction.
Key Themes for 2020Q2 Earnings Season
Although each sector is unique, there are three main factors driving aggregate earnings across the market.
First of all there is uncertainty about the Covid 19 Pandemic itself. Scientists started the pandemic with little knowledge of how the virus spread, and how severe its effects were. Every day, new research comes out about the viruses origins and characteristics. More importantly, scientists are frantically working on developing a vaccine or other treatment. Yet when one is discovered there will be the challenge of production and distribution. Testing capability is limited, making it difficult to ascertain whether a second wave is coming, or whether it’s already here.
The timing, length and magnitude of any second wave in developed markets will determine how long the virus itself impacts company earnings. Part of the reason that the impacts of Covid-19 in New York were so severe is that contagious patients were sent back to nursing homes, leading to widespread deaths. It’s possible that as the virus spreads more in other areas, it will have a lower death rate and smaller impact on society, since we are better equipped to protect high risk individuals. However, society’s reaction to the virus might matter more than the virus itself.
The second key driver of company earnings is public policy and political risk from society’s reaction to Covid-19. In normal times, public policy is at most a tertiary driver of most industries. However, in the wake of the Covid-19 pandemic, entire industries have been shut down by government order. Policymakers face difficult decisions with no good answer. In some cases they will implement extreme lockdowns that crush the virus but also decimate the economy. In other cases, they may take a hands off attitude, only to see the virus destroy consumer confidence.
Travel restrictions have stymied deal making and supply chains. Policymakers are using aggressive stimulus measures to compensate, but it has uneven impacts across different sectors. The Federal reserve can provide support and stimulus, but they can’t print a vaccine, or force scared people to go out and spend money.
Separate, yet related to lockdown and stimulus policies is the rise of populism. Around the world uncertainty and fear are helping the most extreme political ideas come to the forefront. Most major companies face regulatory risk, and the likelihood of extreme changes in regulation has increased dramatically, regardless of who wins elections in the US and around the world.
Finally, there are changing consumer habits and business practices. The virus itself, and the resulting public policy have all changed the way we consume and do business. The big question is whether these changes are temporary or permanent. The answer will vary sector by sector. Consumers are currently cutoff from any entertainment or leisure requiring close social interaction. As they find new ways to spend free time, they will develop new habits that might stick after the pandemic ends. Business travel is now practically illegal. Once social distancing restrictions ease, companies will be hesitant to send their employees to conferences and client visits. Yet face to face interaction plays a vital role in building relationships, and people will seek it out again. Some companies will thrive in the new normal.
The pandemic has had different impacts on different industries. Banks are facing major credit risk now, depending on what industries are in their loan portfolios. Yet panic has driven a surge in capital market activity, and volatility has benefited trading operations. Most banks had contingency plans in place that allowed their workers to be productive remotely. Overall, however, sell side analysts have extremely bleak expectations for the next few quarters of banks earnings. Banks are generally the first to report earnings this quarter, and overall, wall street expectations are bleak. Loan writedowns will decimate the BLX Select Bank Earnings Index, while transactional activity might support the BLX Select Bank Revenue Index.
Although the sectors such as banking and airlines are facing major headwinds, some companies are thriving in the pandemic. Tech companies, especially the FAANG Companies- Facebook, Amazon, Apple, Netflix, and Alphabet have benefited immensely. Since their business models depend more on virtual than real physical human interaction, they have proven impervious to travel restrictions, and lockdowns. Moreover, Covid-19 has accelerated several key trends in society that benefit them. On the other hand, the FAANG companies face increasing political risk that might end up hurting their business models. The FAANG Revenue and FAANG Earnings Indexes reflect the topline and bottom line growth of the most important groups of tech stocks. As stock valuations continue to march ahead of fundamentals for this important group of companies, investors can turn to earnings derivatives to position themselves better for the long term.
Airlines are undoubtedly the most directly impacted by Covid-19. In 2020Q2 airlines experienced the most severe revenue drop in their history. Airlines dependent on international routes are the worst impacted as countries implemented travel bans. Domestic routes are also negatively impacted as various US states require visitors to self quarantine. Analysts across the board expect extremely poor earnings. BLX Airlines Revenue Index is the ultimate covid indicator. It will drop sharply during the next month. As new data comes in, investors will be able to directly express their views on the depth and length of the slump, and take a leveraged position on the eventual recovery.
The following table shows a summary of key factors impacting different industries represented in BLX Global Indexes:
BLX Global Indexes are designed to facilitate trading and hedging of company fundamentals. To help investors prepare for what is sure to be the wildest earnings season ever, the rest of this paper takes a deep dive into wall street expectations, and the key factors investors need to watch.
The Select Bank Revenue and Earnings indexes reflect the health of the banking sector, a key macroeconomic indicator. Each earnings season, banks announce their earnings relatively early, although they don’t file their 10-Qs until several weeks later. JP Morgan, Citigroup, and Wells Fargo will start the earnings season, all reporting on July 14. Goldman Sachs and Bank of America will follow later in the week, as will several other index components.
Wall Street Revenue Expectations
BLX Select Bank Revenue Index dropped slightly during Q1 earnings season, but analysts are expecting an even steeper decline with Q2 earnings. “The upcoming 2Q20 results will be confusing, sloppy, and shocking for some banks, in our view, but our outlook is cautiously optimistic as we expect the economy to continue to gain momentum into the end of the year,” according to Gerard Cassidy, analyst at RBC Capital Markets. Based on the aggregated revenue forecasts, sourced from Tagnifi, the median Wall Street estimate has the index dropping sharply, from 124.8, to 98.4 after this quarter’s earnings are reported.
Covid-19 creates many challenges for banks, yet it also creates opportunities. In the following section, we discuss the key factors that will drive bank revenue and earnings in the medium and long term.
Key Factors to Watch
The biggest risk for banks is that the Covid-19 pandemic turns into a credit crisis. As the IMF has pointed out, the pandemic has exacerbated existing vulnerabilities in the financial system. All banks took major writedowns in their loan books in the most recent quarter. Banks that are overexposed to the most vulnerable industries, such as retail, oil & gas, and travel, will suffer bigger hits to earnings. Consumer credit has also been impacted as unemployment rises. In the first quarter of this year banks built up credit reserves to prepare for writedowns. In this quarter we’ll find out if the reserves are big enough. There still might be problems lurking on bank balance sheets.
Stimulus and Support
The ability of the Treasury Department and the Federal Reserve to support the economy will impact banks more directly than any other sector. Around the world government responses to the Covid-19 outbreak have been unprecedented in terms of magnitude and creativity. According to Deutsche Bank, the Fed balance sheet expanded more in the two months following the Covid-19 outbreak than it did in the four years following the financial crisis. Instead of just buying “safe assets”, the Fed is directly buying junk bond ETFs. Additionally, some unemployed people are receiving benefits that exceeded their prior incomes. These policies will support problematic industries and prop up consumer borrowers while they last.
Another policy factor to consider is record low interest rates. Although a “lower for longer” environment might support many industries’ ability to borrow, low interest rates present a major challenge to banks’ business models. Thus, even though stimulus and support will prop up banks, low interest rates will have an overall negative impact.
Trading and Capital Markets Activity
Although loan losses and narrow interest margins will weigh on bank earnings, trading and capital markets activity will be a major bright spot. Bank executives are always careful not to brag during a crisis, but in the earnings calls last quarter all major banks highlighted elevated trading volumes. JP Morgan, for example, noted that rates and commodities volumes in January were more than triple their average. Considering how volatile markets have been in Q2, it’s likely many banks will report increased earnings from trading.
Additionally, capital markets activity has been strong as more borrowers rushed to lock down cash.
Although trading and capital markets can deliver significant profits, investors also need to be on high alert for any risk management lapses that might occur.
The FAANG stocks are representative of the new digital economy, and key drivers of the overall market.. Earnings season for FAANG starts with Netflix, which will report on July 16. One week later, Amazon, and Facebook which represent 36% and 20% of FAANG revenue, respectively, will report. Facebook and Apple will top off FAANG earnings season in the last week of July.
Wall Street Revenue Expectations
So far, the FAANG companies have had a great crisis, The covid-19 lockdowns around the world have accelerated several long running trends that were all favorable to FAANG stocks. FAANG Revenue has been steadily marching up over the past few years and analysts continue to have bright expectations for the future. Based on the aggregated revenue forecasts, source from Tagnifi, the median Wall Street estimate has the index increasing from 257 to 274 after the new earnings reports come out.
Can the upward march in FAANG Revenue continue? The next section covers key factors to watch for.
Key Factors to Watch
Changing Consumer Behavior and Business Practices
As people stay at home to Netflix and Chill, rather than going to dinner and a movie, the value of a Netflix subscription increases. With retail outlets closed, people are buying more on Amazon- building habits that will likely last long after the lockdown eases. In general, as people spend more time on the internet, there are more eyeballs on the advertisements that Facebook, and Alphabet sell.
The FAANG companies are so big and so successful that political scrutiny is inevitable. Recent events suggest that political risk for FAANG companies is increasing. The Covid-19 lockdowns and riots along with the broader trend towards populism heighten the risk of regulatory changes seriously impacting the financial bottom line. General regulatory risk is intertwined with antitrust issues.
Recently, major advertisers boycotted Facebook. Yet major advertisers are only a small portion of Facebook’s overall revenue. A long tail of smaller advertisers accounts for nearly 80% of Facebook’s revenue. Furthermore, Facebook is able to systematically fill in the gap with smaller advertisers. Consequently this is unlikely to impact Facebook’s top line. Although the media is overreacting to the boycott, it is reflective of a much more serious political risk that the Facebook, and its big tech peers will face
The market power of FAANG companies is attracting the attention of academics and practitioners specializing in antitrust. Additionally, for companies like Google and Facebook that rely on user generated content, there are increasing demands for them to take responsibility for scams and hate speech.
CEOs from Facebook, Amazon, Apple, and Google have all agreed to testify before the house judiciary committee, giving into immense pressure after more than 60 organizations including signed a letter to the House Judiciary Committee urging them to subpoena testimony from key FAANG executives.
Attacking FAANG companies is one of the few ideas that unites both the left and the right in the highly divisive political environment. American Economic Liberties Project, a progressive group, and Internet Accountability Project, a conservative group, co led a letter to regulators. It is highly likely that one or all of the major tech companies will be forced to provide potentially incriminating documents, and send their executives to humiliating testimony before the House of Representatives. Congresswoman Jan Schakowsky and Senator Richard Blumenthal publicly demanded that the FTC take action against Google for its failure to stop scams on its platform. On the right, Fox news Anchor Tucker Carlson called for a Republican primary challenge against Utah Senator Mike Lee, because of his support of large tech companies.
Regardless of who wins the election, the FAANG companies will be fighting a losing battle against increased regulation. At best it will diminish profitability as they spend more resources on compliance. At worst changes in regulation will permanently diminish their revenue models.
Extreme Stock Valuations
Even if FAANG companies continue to capitalize on social trends, and avoid disruptive regulatory action, there is no guarantee that the companies stock prices will continue their steady upward march. FAANG stock valuations are greater than the overall market, reflecting a cheery consensus. Although high valuation is arguably justified for fast growing dominant companies, a review of market history reveals reason to be concerned.
Any investor who experienced the last tech bubble is aware that good companies don’t automatically make great stocks. Investors who bought Microsoft in December 1999, suffered a 74% drawdown, and didn’t get back to even until October 2016, even though Microsoft grew revenue 416% during that time. Investors who bought Amazon in December 1999 suffered a 94% drawdown, and didn’t get back to even for 10 years, even as the company grew revenue by 1495%. Although current conditions are different, the tendency for stock valuations to mean revert is consistent throughout market history. Whether or not the current valuation of FAANG stocks fits with long run fundamentals, extreme valuation suggests that investing directly in FAANG earnings using earnings derivatives might be a better tool for expressing a bullish view.
The BLX Airline Revenue Index provides a direct view on how Covid-19 and its second order consequences are impacting the economy. The three main components of the BLX REvenue Index are Delta Airlines, American Airlines, and United Airlines. Delta and United will report earnings on July 14, with American and Southwest, along with other airlines reporting in the following week.
Wall Street Revenue Expectations
During 2020Q1 earnings season, the BLX Airline Revenue Index dropped only slightly, from 138, to 134. However, the first quarter only included the beginning of the Covid-19 crash. In the second quarter Covid-19 has started to have a severe impact, causing sell-side analysts to revise their forecasts down multiple times. Based on the aggregated sell side revenue estimates, analysts expect the index to drop sharply down to 62 during this upcoming earnings season. Stocks might respond differently depending on whether earnings reports are less bad than expected. Management will also provide some color on what to expect for the rest of the year, although uncertainty will remain elevated.
The following chart shows what the Median Wall Street Estimates show for the BLX Airline Revenue Index.
Never before in history has there been such a sudden and sharp drop off in airline revenue. The big question for investors is how long it will last. In the next section, we discuss key factors that will influence the medium and long term trajectory of the BLX Airline Revenue Index.
Key Factors to Watch
Public policy responses to Covid-19 around the world will be a key driver of airline revenue both this quarter and in the coming quarters. According to Kayak, there are 175 countries with travel countries, including 106 that are completely closed. International travel restrictions cut off a major source of revenue for airlines. Domestic travel within the US has also dropped off sharply. Some states, such as Massachusetts are opening up, although most companies are still allowing people to work from home. Others such as Texas and Florida are just beginning to experience major surges of positive cases. Since so many US states have 14 day quarantine requirements for out of state visitors, business travel still isn’t viable. The longer these draconian restrictions last, the more severely airline revenue will contract.
Of course, if governments loosen up restrictions, it’s no guarantee people will return to travelling.
Long Term Habit Changes
People have drastically changed their habits in the wake of Covid-19. The future of the airline revenue depends on whether those habit changes are temporary or permanent. Its possible consumers will avoid travel even after restrictions lift. Occasional resurgences or even rumors of outbreaks are likely to cause people to cancel travel plans. On the other hand, search traffic at travel sites has increased. It’s possible that people suffering cabin fever in locked down states will overcompensate by travelling more after restrictions ease. The crowds in the recently reopened Las Vegas indicate that we might be overestimating the permanence of Covid-19 consumer habit changes.
What about business travel? It’s clear that many companies have discovered that their employees can be more productive working from home. Videoconferencing can replace many in person meetings. Yet Zoom fatigue is a real issue. People can only attend so many webinars. Real face to face interaction is critical for building real business relationships. Although business travel will change, it’s unlikely it will go completely away. Conferences will find a way to attract people at marquee destinations. Investors will still need to do on the ground due diligence in some industries. The key question for investors is how long it will be before business travel returns in a big way.