Macro: Sandcastle economics
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Q3 earnings preview; small caps are shining; Rolls-Royce roars back
Peter Garnry
Chief Investment Strategist
Summary: Analysts expect S&P 500 earnings to increase 49% q/q as companies are bouncing back from the abyss in Q2. Recent macro figures and many positive earnings surprises make us confident that Q3 earnings will deliver what is needed to sustain the rally in equities. Investors seem to have begun adding reflation and growth bets again with small caps outperforming the past week and other cross assets reflecting this theme. We also take a look at Rolls-Royce that is fighting to survive through a $6.5bn financial deal that starts today with the launch of its senior unsecured USD bonds.
Global equities have settled in a trading range and could stay there for until the US election. Market participants need a new narrative. Yesterday, a new narrative was forming as reflation trades were put on again (growth stocks, small caps, long-term yields higher, gold etc.) partly driven by a positive spin on a Biden victory and higher probability of Democrats delivering a clean sweep. In that case, the recent House bills of $2.2trn could move through the Senate and deliver a sizeable boost to the US economy.
Q3 earnings must deliver
That is a strong narrative, but in the meantime equity markets need to see Q3 earnings rebound. Elevated equity valuations are discounting a significant rebound in earnings and analyst estimates are also reflecting this with expectations looking for a 49% q/q increase in Q3 earnings per share in the S&P 500 Index. In other words, there are steep expectations going into the Q3 earnings season which really kicks into gear next week with US financials. Despite a strong rebound in earnings analysts do not expect earnings to soar past pre Covid-19 earnings until Q2 2021.
We remain quite bullish on the Q3 earnings season. Many recent earnings releases (those ending 31 August) from companies not following the calendar year have been much better than estimated with positive reactions in the stock price. Yesterday’s record August retail sales in Europe and better than expected ISM Service Index for September in the US are bolstering our view that most companies are well ahead of expectations and that earnings estimates are mostly too conservative.
Small caps are feeling the love
The reflation we have covered today on the back of yesterday’s cross market price action has also been reflected in small caps. Expectations of more stimulus in both the US and Europe will naturally lift the part of the equity market that suffered the most during the severe lockdowns earlier this year and that was certainly smaller companies. The stronger than expected macro figures lately are also underpinning a growth surprise and investors seem to be betting on this theme through small cap stocks. As the chart below shows small caps in Europe started outperforming last week and has accelerated this week. The same pattern shows up in US equities.
Rolls-Royce starts tapping bond market
Rolls Royce shares are up 10% again today extending the gains to 35% from the lows on Friday. The jet-engine maker is starting its senior unsecured noted in USD which is part of its $6.5bn rescue plan to get the company through its demand shock due to Covid-19. Analysts expect revenue to decline 34% in 2020 and delivering negative free cash flow of £4bn which is quite significant since the company’s enterprise value is only £7.2bn. The current net debt is around £4.5bn and expected to rise another £1bn under the new financing plan. To not lose grip of the situation Rolls-Royce has to keep its net-debt-to-EBITDA at no more than 3x which implies that EBITDA should quickly get back to £1.8bn which is where the company was in 2016 before things came apart. Rolls-Royce is a very high risk opportunity for investors, also reflected in its 9.2% 1-year default probability (Bloomberg’s default risk model), but carries an attractive risk-reward ratio if the economy heals faster than expected and commercial aviation can come back. But that is a very big unknown.
The five-year chart is EU compliance requirement.
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