What to expect from Q3 earnings season

On the latest edition of Market Week in Review, Head of Equity Portfolio Management for North America, Megan Roach, and Head of AIS Portfolio & Business Consulting, Sophie Antal Gilbert, discussed key themes emerging from third-quarter earnings season as well as the main issues dominating company management commentaries. They also reviewed the latest macroeconomic data releases from the U.S. and Europe, and assessed recent market performance.

Key themes emerging from Q3 earnings season

With approximately 20% of S&P 500 companies reporting results, the strong start to U.S. third-quarter earnings season shows no signs of letting up, Roach said. “Consensus expectations are for 14% year-over-year revenue growth and 29% year-over-year earnings growth,” she stated, “and so far, 84% of reporting companies have exceeded analyst estimates by about 14%.” The impressive results so far continue this year’s theme of above-trend corporate earnings growth, Roach added, noting that both the first and second quarters of 2021 also handily crushed expectations.

In addition, several key themes from the second quarter have carried over to the current earnings season, she said, including value over growth, small cap over large cap and European equities over U.S. equities. Focusing in on the outperformance of value stocks compared to growth stocks, Roach noted that value sectors such as energy, materials, industrials and financials have seen impressive margin improvements. “This is resulting in expectations for the earnings growth of value stocks to outpace the earnings growth of growth stocks by a factor of about two to one,” she stated, noting this is exactly what occurred during second-quarter earnings season.

Similar to last earnings season, smaller cap companies are also expected to outperform their larger cap counterparts, Roach said, with earnings growth expectations for small cap companies of around 40% - versus 29% for large cap companies. Lastly, with consensus expectations for 33% year-over-year earnings growth, European companies are expected to outpace their U.S. counterparts, where growth expectations are a bit lower, at 29%, she noted. “This strength outside the U.S. can also be seen in the stronger growth rates of the more globally oriented companies within the S&P 500, when compared to the domestic names,” Roach remarked.

U.S. housing starts decline during September

Zeroing in on the topics discussed during company management commentaries, Roach said that surging energy and commodity prices, labour shortages and supply-chain disruptions are the issues most frequently mentioned in third-quarter results and forward guidance. “This comes as no surprise, as investors are increasingly turning their attention to how rising inflation will impact consumer demand for goods and services - and whether individual companies will be able to absorb these higher costs or pass them along to consumers,” she explained.

New-home construction is one area where these issues are coming into play, Roach said, noting that U.S. housing starts fell for the sixth straight month in September. Completion times are also running longer due to shortages in materials and labour, she added. However, sales of existing U.S. homes did improve in September, Roach noted, rebounding by 7% from August. “Mortgage rates have drifted up over the past few months and are expected to climb higher next year, which is probably encouraging people to purchase homes sooner rather than later,” she remarked, noting that inventory also remains tight.

New surveys suggest growth cooling off in Europe, U.S.

Turning to the latest economic data releases, Roach said that IHS Markit’s composite PMI (purchasing managers’ index) for the eurozone came in a bit weaker than expected, falling for the third straight month. This, she explained, is indicative of a slowdown in the region’s growth rate. A similar trend was captured in the U.S. by the Conference Board’s Leading Economic Index for September, Roach noted, with the index only rising 0.2% in September - versus 0.8% in August.

Meanwhile, data pertaining to U.S. employment was more positive, she said, with new jobless claims for the week ending 16 October dipping to 290,000 - the lowest level since the coronavirus pandemic upended the labour market in March 2020. “Prior to the onset of the pandemic, new unemployment claims averaged about 220,000 per week,” Roach explained, “so these latest numbers bring the U.S. the closest to normal in quite some time on the employment side of things.” The drop in jobless claims shows that companies are increasingly avoiding layoffs, due in large part to widespread labour shortages in several industries, she noted.

What’s powering the rise in equity markets?

Roach concluded the segment with a look at recent market performance, which she characterised as relatively calm. She noted that the U.S. 10-year Treasury yield rose steadily during the week of 18 October, from approximately 1.57% to 1.68%, while global equity markets ended the week up about 2%.

“The strength in equities was driven by more cyclical areas of the market, including the financial, industrial and consumer discretionary sectors,” Roach stated, adding that this is reflective of the strong earnings growth seen in these sectors.

Ultimately, while there’s still a fair amount of uncertainty in markets over rising inflation and potential changes to monetary policy, strong earnings growth and an anticipated increase in capital expenditures in 2022 provide reasons for optimism on the trajectory of the economic expansion, Roach concluded.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

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