The earnings outlook in a recession

Last week, our economists shared their thinking on the likely scenarios for the global economy in the months ahead. Their work feeds into my own analysis of the outlook for corporate earnings.

Given the extreme circumstances, I use two models that approach earnings forecasts from different perspectives.

The classic approach is designed to translate macro scenarios from our economists into consistent earnings forecasts. This draws on sales-weighted GDP growth, corporate margins, and a measure of slack in the economy.

Given the unique challenges posed by the current crisis, to cross-check the model for today’s environment I also used a sector-based approach that feeds in data on the peak-to-trough earnings declines for US sectors during both the 2000-2003 and the 2007-2009 recessions.

These were larger than average earnings recessions (-44% and -54% respectively), but are likely to be closer to what we’re facing today than some of the more historical episodes. This data gives us a more quantitative framework for considering how sector earnings may react this time.

This is important because the earnings decline is arguably the best starting point when considering how far equities can fall in this bear market. In most cases the equity drawdown has been a bit smaller than the peak-to-trough earnings decline, and this is my base case this time as well. Other factors obviously also matter: starting valuations, sentiment, sector effects, etc.

Overall, we expect a much larger collapse than the market seems to be pricing in: our estimates imply that in Tim’s Scenario 2 earnings decline by around 40-50%.

Silver linings

However, it is worth noting some more encouraging insights that came from taking the sector-based approach rather than looking only at the classic earnings model.

First, the sector composition of US equity markets in 2020 should help mitigate the extent of the aggregate earnings drop relative to 2008. Two of the worst-performing sectors in 2008, namely financials and energy (the latter is likely to be hit especially hard in this drawdown given the supply- and demand-driven collapse of the oil price), now have around half the index weight in the US that they had then.

Second, the weighting to technology stocks in the main US indices has roughly doubled since the financial crisis. We should remember that some tech companies are now ‘hidden’ outside the official information technology sector. Amazon is part of the consumer discretionary sector, for example; Facebook, Alphabet/Google, and Netflix are all in the communications services sector.

There is good reason to expect technology names, broadly defined, to prove more resilient in this crisis than other sectors and especially 2008’s index heavyweights of financials and energy. Technology is less cyclical thanks to subscription-based business models and the secular transition to a more online economy, as well as including many beneficiaries from the current imperatives of remote working and social distancing.

We should not minimise the impact the economic downturn will have on corporate earnings: the decline will likely become one of the largest on record. But a level-headed and multi-pronged approach to earnings forecasting should help us find ranges at which medium-term value in equities emerges.