Earnings season kicks off today, with aluminum producer Alcoa Inc. (AA) reporting its quarterly results after market close. Expectations ahead of the earnings season have been low, with total earnings for companies in the S&P 500 expected to show a decline following eleven quarters of growth. However, expectations were quite low ahead of the previous earnings season as well. Still nearly two-thirds of the companies in the S&P 500 managed to beat guidance that time. So is it going to be the same this time around, or is the corporate earnings growth story coming to an end?
Since the financial crisis, companies have been able to post earnings growth even as other areas of the economy continued to struggle. This growth has been generated by cutting costs and trimming workforce, allowing companies to expand margin. However, growing earnings through margin expansion is expected to be exhausted at some point. If analysts' predictions are correct, that is going to happen in the third quarter.
The big question though is: will the rally in the equity market as seen so far this year stall, given that the third quarter indeed turns out to be as dismal as analysts are predicting? This is very hard to predict. Stocks have been rallying this year despite everything - increasing worries over the debt crisis in the euro zone, a slowdown in the global economy and the looming U.S. fiscal cliff. Stocks have defied economic fundamentals mainly due to the ultra-loose monetary policies from central banks across the globe. So if I go by this rationale, the rally will continue even if the third-quarter numbers are as weak as expected.
Also, financial markets are forward looking. Therefore the focus is not going to be so much on third-quarter numbers as it is going to be on a company's outlook. A gloomy outlook therefore could stall the rally.
In the last two days, the World Bank and the International Monetary Fund (IMF) have trimmed forecast for East Asian economies and the global economy, respectively. Data from the euro zone and China continue to be weak. In the U.S., the latest job report threw a positive surprise; however, the overall outlook is gloomy, primarily due to the fiscal cliff. The fiscal cliff, along with a hard landing in China, are perhaps the biggest risks facing the global economy. Given all these factors, the outlook from companies for the fourth quarter and beyond is expected to be weak.
In terms of individual sectors, Basic Materials looks the worst bet right now. Alcoa will kick-off the earnings season for the sector. Analysts expect the company to report weak quarterly results, which is not surprising given the weak pricing environment. This is going to be the case with the entire sector. However, as I said earlier, the outlook will be more important. Here again, I expect Alcoa and other metal and mining companies to disappoint, mainly due to weakness in China.
Commodity prices have risen in the past year. The Fed's aggressive bond-buying program, along with easing from other major central banks, sparked a rally in commodities. However, a rally driven by easy monetary easing is not likely to be sustained. It is true that the previous two rounds of quantitative easing sparked huge rallies in commodities. It may be recalled though that the sharp rise in commodity prices back then was also driven by strong growth in commodity hungry economies like China and India. Growth in both these countries is well below those levels now, so I don't expect a sustained rally in commodity prices. Therefore my outlook on the Materials sector is bearish.
In the Technology sector, PC makers HPQ and Dell Inc. (DELL) are the ones I am bearish on. PC makers are not only suffering due to a weak macro environment but also due to a fundamental shift in the industry. With more and more consumers switching to mobile computing (tablets, smartphones), PC makers are seeing weakening demand.
Financials look like a good bet at the moment. In fact, analysts surveyed by Bloomberg are the most bullish on this sector. Within the sector, traditional lenders could post robust earnings growth in the third quarter due to a pick up in mortgage lending. JPMorgan Chase & Co. (JPM) and Wells Fargo & Company (WFC) will be the first among major U.S. banks to report earnings.
Overall, the third-quarter results and outlook is expected to be weak for companies that are more dependent on the global economy. This is not to say that companies focusing primarily on the U.S. market don't face uncertainty. The biggest near-term risk is the U.S. fiscal cliff. It would be interesting to see what companies reporting in the next few weeks have to say about the fiscal cliff issue.