By Philip Lawlor, managing director, head of Global Markets Research
Consensus EPS forecasts are stuck in limbo as analysts struggle to predict the unpredictable amid a fast-moving health crisis and a scarcity of hard data. Though estimates continue to point to a robust global earnings recovery this year and next, no one believes them.
But bond-market signals and history can help to size up what’s coming.
Extrapolating from longstanding predictive relationships, the recent break in 10-year US Treasury yields to all-time lows is signaling a sharp contraction in the US ISM Manufacturing Index, a key leading economic indicator, to around 40 from the modest expansionary reading in February. As Chart 1 shows, these ISM levels correspond to a nearly 3% drop in US GDP—and are on a par with those preceding the past two recessions.
There is also a historically close relationship between shifts in the US ISM Manufacturing Index and six-month revisions to 12-month-forward EPS forecasts. If bond-market signals prove accurate about the magnitude of the hit to US manufacturing activity, a wave of negative EPS revisions looks imminent, possibly comparable to what happened in the aftermath of the global financial crisis.
For most markets, the resumption of the downtrend in forward EPS forecasts (after a brief lull earlier this year) would erase much, if not all, of the upswings since early 2018. The notable exception is the Russell 1000, where forward EPS estimates have remained relatively stable for the past year and slower to respond to recent revenue and operating-leverage pressures.
As we brace for a cascade of profit warnings to unfold, the market response to the downgrades will be a useful gauge of what has already been discounted.
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