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Along with global markets, Australian equities have enjoyed a rebound in recent weeks even as the earnings outlook has deteriorated. This note provides an outlook on both U.S. and local earnings and market valuations, and attempts to gauge the extent to which the ‘bad news’ is already priced in.
A mighty market rebound
As seen in the table below, equity markets have enjoyed a solid rebound following the heavy decline over February to late March. After a peak-to-trough decline of 34%, the S&P 500 has since rebounded by almost 30% – leaving a net decline since the peak of around 15%. In this time, however, forward earnings estimates have declined by almost 20%, meaning the market’s price-to-forward earnings ratio (PE ratio) has in fact edged higher to around 20. At the recent market low, the S&P was trading at a PE ratio of 13.8.
In Australia, the overall decline in the market since its peak has been somewhat larger – at around 25% – while the decline in forward earnings has been a little less at 16%. This has meant the PE ratio has eased back somewhat, from 18.4 at the peak to a more reasonable 16.2. At the recent market low, the S&P/ASX 200 was trading at a PE ratio of 12.4.
Market and earnings performance since peak
Further declines in earnings likely
Judging by the scale of earnings declines in past recessions, further earnings downgrades seem likely in the months ahead. As covered in a recent note on the U.S. market, if equity prices remain unchanged, this would push up PE ratios even further. Indeed, since that note was prepared, U.S. earnings expectations have continue to decline – with the expected level of CY ’20 earnings revised down by a further 7%.
The table below sets out what I consider one possible (and reasonably likely) scenario – which is a decline in earnings broadly in line with that seen in recent recessions.
As evident, the expected level of U.S. earnings over the next three years has already been scaled back notably since the market peak back in February. CY ’20 earnings are now expected to decline by 19.5% compared with expected growth of 6.7% back in January. In keeping with past recessions1, let’s assume analysts ultimately pencil in around a 35% decline in US CY ’20 earnings though, unlike in the past two recessions, let’s conservatively assume analysts retain an expected rebound in earnings growth for the year after. This would still imply a notable decline in forward earnings and a rise in the PE ratio (at current prices) over the next few months – to levels not seen since the dotcom bubble two decades ago.
Australian & U.S. forward earnings outlook
Source: Bloomberg. Future outcomes are inherently uncertain. Actual outcomes may differ materially from those contemplated above.
The Australian situation is also challenging, though perhaps a little less extreme than in the United States. As seen in the table above, FY’20 earnings are now expected to decline by 19.2% – compared to a flat earnings growth expectation back in January. Assuming analysts pencil in a 30%2 expected decline in earnings by August, with moderate 10% growth in the following two years, the implied further decline in forward earnings would push up the PE ratio to 17.8 based on current market prices. That’s a little less than at the market peak in February, but still well above long-run average levels.
How low could markets go?
While not a prediction, I note that if both the U.S. and Australian markets were to see the decline in forward earnings anticipated, and investor fear at that time resulted in their PE ratios being pushed back down to their late-March lows (i.e. 13.8 and 12.4 respectively), it would imply a decline in the S&P 500 and S&P/ASX 200 to 1,650 and 3,700 respectively – or a peak-to-trough decline of around 50% for both markets.
This would be broadly in line with the decline in both markets during the GFC a decade ago – and also in line with the decline in the U.S. market following the dotcom bust and 2001 recession.
Second wave fears
At present, equity markets continue to express hope that economic growth can quickly rebound as social distancing restrictions ease. That said, given the lack of herd immunity and absent better drug treatments, history suggests a second wave of infections – at least somewhere in the world – remains a very high risk, which could ultimately result in lockdowns being re-imposed.
Either way, even the risk of a second wave could well result in subdued global business and consumer behaviour for some time – undermining hopes of a sustained strong bounce back in economic growth.
1. In the last two US recessions, earnings fell by 17% in 2001 and were flat in 2002. Earnings declined by 32% in 2008 and were flat in 2009.
2. During the GFC, Australian FY’09 earnings declined by 29%, with a 15% recovery in 2010. In the more serious early 1990s recession, earnings fell by 10.2%, 21.9% and 32.1% over CY’90, CY’91 and CY’92 respectively.