Head of Equity Strategy
Summary: Earnings continue to be better than expected and Microsoft's earnings were a relief for investors given the strong result in their cloud business against a weak backdrop from Intel and SAP. We are also getting good earnings from Boeing, GE, and UPS ahead of the US equity market open, but Mastercard is on the other hand disappointing. But rebound in earnings and more optimistic businesses are not enough to offset risk-off sentiment related to the increasing probability of a new dip in economic activity in Europe as countries such as France is considering a new national lockdown to halt the rapid surge in new confirmed Covid-19 cases. We also take a look at the VIX curve backwardation which is recollecting awful memories from earlier this year when markets were tumbling.
Earnings releases continue to be strong across the board with 83% earnings beat rate in the US. Ahead of the US equity market open we have got strong earnings from companies such as UPS, GE, and Boeing. Meanwhile the risk-off in global equities has intensified with European leading the declines and the VIX curve firmly back into backwardation suggesting more short-term pain ahead.
Microsoft earnings were a relief and UPS is unable to predict
On Monday we highlighted the importance of this week’s earnings with the Trillionaires’ Row (Microsoft, Apple, Apple, and Alphabet (Google) are all companies with market value above $1trn) reporting earnings. Last night after the close, Microsoft reported strong revenue and earnings figures blasting estimates and improving S&P 500 quarterly EPS growth q/q to 26%. Microsoft saw strong adoption across of businesses and the cloud segment strongly grew 22% y/y beating estimates and investors could be relieved that the worse than expected cloud business results from Intel and SAP had not impacted Microsoft. It should be said though that the Intelligent Cloud segment experienced negative growth q/q (see slide below from Microsoft’s earnings presentation) Tomorrow after the US market close, we will get earnings from Apple, Amazon, Alphabet and Facebook which will represent a big part of the US equity market and settle the Q3 earnings season.
Among earnings in US pre-market session Boeing is the most dramatic. The company delivers Q3 revenue at $14.1bn down 29% y/y and better than the estimated $13.8bn, but the company says it will cut the workforce to adjust to a ‘new reality’ which is that of lower demand for commercial airplanes in the foreseeable future as IATA does not see commercial aviation returning to passenger traffic numbers from pre-Covid-19 levels until 2024-2025. On the positive side of Boeing’s earnings, the cash burn has stopped for now, but the Covid-19 and 737 MAX scandal has reduced revenue by 40% in two years and the company is looking into a FY21 reality of net debt of $31bn with around $8bn estimated EBITDA to support that debt. It is manageable but a leverage factor at the high-end suggesting Boeing will have to reduce R&D and other operating expenses to focus on shoring up its balance sheet. An alternative would be to tab into the equity to reduce the balance sheet leverage. With the current numbers, Bloomberg’s default risk model has Boeing’s 1-year default probability at 4.6%. The 5-year CDS market is pricing the debt at 253 basis points which is high but lower than would Bloomberg’s default risk would suggest.
Other earnings stories today are good earnings from UPS that are still benefitting from the transition to e-commerce and more packages that need to be delivered, but the logistics company is not willing to commit to any outlook as the company still finds the future too unpredictable. MasterCard disappoints with Q3 revenue down 15% y/y and cross-border volumes down 36% y/y compressing earnings which are coming slightly below estimates.
The backwardation game in VIX and bleeding in Europe continues
Global equities are in risk-off mode driven by rapidly rising Covid-19 cases in the US and Europe suggesting a violent second wave as winter is approaching. In Europe, several countries are close to maximum intensive care unit capacity and France is considering a new national lockdown for one month starting on Friday. Germany is tightening its mobility restrictions and overall, it increases the risk of another dip in the European economy. As a result, STOXX 50 futures are down 3.4% today and down 13% from its local closing high on 21 July. The index is breaking below the level where the May breakout to the upside happened and thus the market is opening up for declines down to around the 2,800 level suggesting around 5-6% more downside in European equities in an extended risk-off scenario.
On top of this, the lack of breakthrough on a US fiscal deal ahead of the US election on Tuesday is also adding to the weaker sentiment. The worst-case scenario is no fiscal stimulus and then a potential victory to Biden which could create a fiscal impulse gap for months just when the US economy needs the most help to sustain the rebound trajectory. The contested election result and a Biden victory without the Senate control are also outcomes that are lurking on the horizon. Adding it all up the volatility market is forcefully returning to backwardation (that is downward sloping VIX futures). The difference between the current 2nd and 1st VIX futures contract is around -13% which reflect heightened uncertainty and normally negative return expectations for equities.
In general, it has been a good year for volatility with the iPath S&P 500 Dynamic ETN up 113% this year as of yesterday’s close. This ETN is dynamically long VIX futures and rolls the positions as the VIX futures expire, and hence the ETN benefits from higher volatility.
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