S&P 500 earnings growth flipped back to slightly positive in the fourth quarter (+1.3%) on a year-over-year basis after turning negative in the previous quarter (-1.2%). While results were relatively flat, they were once again better than anticipated, with earnings coming in ahead of estimates that expected a change of -1.3%. The market initially reacted positively to the results and continued to move higher. One year forward P/E ratios peaked at over 19x, which was a post-financial crisis high and reflected the recent progress in tariff negotiations, i.e., the phase one deal with China and the United States-Mexico-Canada (USMCA) deal, optimism that central banks will remain supportive to the global economy, and lack of investment alternatives in a low rate environment. It also indicated a view that earnings growth will remain positive in the first quarter and will accelerate into the end of the year.
All of this changed dramatically later in the earnings season when coronavirus headlines took center stage. The market subsequently declined by approximately 13% and P/E ratios retreated to 17x. Looking forward to 2020, earnings growth expectations are being revised lower. First quarter growth estimates were taken down the most, moving from +3.3% to start the year to -0.6% currently. Estimates were revised down by lesser amounts in subsequent quarters with the second quarter moving from +4.9% to +2.5% and third quarter moving from +9.4% to +8.2%, which at the time of publication implied relatively short-term implications for future earnings from the coronavirus.
Exhibit 1: Our thoughts from a fixed income perspective: sector results relative to expectations
|Negative||Modest negative||Neutral/mixed||Modest positive||Positive|
|Basic Materials||US Banks & Other Finance||Construction/Real Estate|
Source: Aegon AM US.
Coronavirus early commentary: During the fourth quarter earnings season, time spent discussing US-China trade negotiations took a back seat to the coronavirus. The majority of management teams provided initial thoughts related to the virus within their opening remarks, but also took time to answer multiple coronavirus questions from the analyst community.
As the earnings season progressed, companies provided more in-depth color regarding the effect the virus was having on overall operations and demand. Several management teams tried to quantify the financial impact from the virus, but it felt like CFOs were pulling numbers out of thin air. Other companies said it would have a negative effect, but it was way too early to call.
Much of the commentary was focused on operations located in China. Key themes discussed included lack of employee availability, low factory utilization, general travel restrictions and the impact on Chinese retail demand. Executive teams spent less time mentioning demand weakness and focused primarily on worker shortages, which made it difficult to ramp-up factories and serve customers following the Lunar New Year holiday. A majority of the sectors experienced some level of impact in mainland China, but the level of disruption varied, with automotive, casinos chemicals, lodging and cruise lines, manufacturing, mining, retailers, and supermarkets most affected. One global lodging company explained, "We began to see the impact of the coronavirus on our business in mid-January with occupancy declines gradually spreading from Wuhan to other markets in the Asia-Pacific region... At the end of 2019, we had 375 properties with roughly 122,000 rooms across Greater China, representing 9% of our total global rooms. Around 90 of these properties are currently closed."
After examining multiple transcripts of S&P 500 constituents, the travel restrictions in mainland China were the most disruptive. These restrictions caused worker shortages at both factories and service companies. In addition, the restrictions resulted in inventory levels rising at factories and falling at customer locations. Retailers, entertainment venues, and restaurants also experienced fewer visitors. One major food products company explained, "Similar to other companies in China, all aspects of our in-country supply chain are operating slower and at higher cost than normal. From a sales perspective, the demand for our foodservice products, which represent the majority of our sales in China, has dropped off considerably as patrons are not eating out. On the other hand, we have seen a large uptick in retail sales of shelf-stable products as consumers dine at home. We do expect a very difficult second quarter for international, primarily due to the impact of the coronavirus."
The coronavirus played into several companies guiding below next quarter's estimates, but many also expect demand to be recaptured throughout the remainder of 2020. The exceptions include airlines, casinos, cruise lines, hotel operators, and restaurants.
Coronavirus effect on fiscal year 2020 earnings guidance: With the quarterly earnings announcements over the last couple of months, most companies have either provided initial fiscal year 2020 guidance or updated previous guidance. Generally, companies have highlighted an expectation of a steady, but slowing macroeconomic environment. Further, outlooks in certain sectors call for the second half of 2020 to see a lift due to phase one of the US-China trade agreement. However, as detailed above, the coronavirus is negatively affecting many sectors. Due to the rapid evolution of the virus, companies have struggled with incorporating those risks into their guidance. As such, it is important to look at the various ways companies addressed their full-year guidance. Existing guidance is likely to come down as the implications to earnings become clearer.
Depending on the timing of the earnings announcement, some companies realized the extent and the effect the coronavirus could have on this fiscal year's results. As a result, a few management teams estimated the potential headwinds and incorporated those estimates into their guidance. Given exposure to China, the automotive sector was one of the first sectors to see the impact of the virus. Automotive production delays and reduced demand was expected into February with recovery in March. However, estimates in the sector generally do not extend beyond this initial interruption. The lodging and leisure sector was also quick to realize the negative impacts from the virus. A global lodging company stated, "While it is still early days, drawing on the industry's experience with SARS and other similar situations, we've tried to estimate the potential impact on our business. Assuming the outbreak lasts around three to six months, with an additional three to six months recovery period for the full year, we would estimate a potential 100 basis point impact to comp system-wide RevPAR growth."
While some companies estimated the negative impact, a number of companies provided guidance excluding any potential headwinds from the coronavirus. Of note were lodging and leisure companies that all should be significantly impacted. Similarly, technology companies expected minimal impact to their business, so their guidance doesn't reflect any effects from the coronavirus. Despite the issues with the China auto market, a US-based auto company speculated that it was too early to assess the impact of the virus on its guidance.
Lastly, a select number of companies chose to pull full-year guidance until they could properly assess the impact of the virus. A global beverage company that has been forced to close a number of stores in China and given the scale, duration and expected recovery, decided it was prudent to pull guidance. Similarly, a gaming company saw too many unknowns as it related to its Macau properties and chose to remove its full-year guidance, explaining, "Given the current environment, we have decided to remove our 2020 financial target. But with that being said, organic growth in our US business...has been tracking in line with our expectation and we see the strength in our underlying domestic business continuing from the fourth quarter into this year." In what could be more common, a major US-based airline initially provided guidance with its earnings announcement, but subsequently announced they were pulling full-year guidance.
Fourth quarter results were overshadowed for many management teams as earnings season wound down just as the emergence of the coronavirus took hold of the markets. Uncertainties within multiple sectors ballooned into several firms pulling full-year guidance, while others conceded that it was too early to tell how the virus will affect their internal projections. We believe the effects of the coronavirus will remain one of the main variables that will effect growth in the next quarter. However, for the most part, we are seeing companies attempt to mitigate the risk that the virus poses to demand, supply chain and earnings.
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