The US equity markets are largely trading at pre-covid19 levels, after recovering more than 50 per cent from March lows. Meanwhile, the recovery in Europe has not been as fast, with European Indices still trading 15 per cent lower than peak levels. While the unprecedented level of stimulus can explain the risk on mode in equity markets during the second quarter, the improvement in economic data and earnings sentiment is currently moving markets, driving returns across a wider spectrum of sectors and shaping the current cyclical rotation.
Over the past three months, returns across sectors of a cyclical nature have outperformed the overall market and exceeded the performance of more defensive stocks. The cyclical rotation is particularly evident in the US, with strong double digit returns across the industrials, consumer discretionary and materials sector. The procyclical rotation has continued over the month of August, with returns across industrial, energy and financial companies leading month to date returns.
As economic growth expectations have declined, earnings expectations for companies were in aggregate also revised lower. In fact, second quarter earnings season have shown that earnings were materially impacted by the COVID-19 pandemic. Collectively, the S&P 500 companies that have reported so far, recorded a nine per cent drop to their bottom line during their second quarter. However, earnings numbers were not as bad as expected. The second quarter earnings season has managed to surprise positively, with US companies recording an earnings level that was 22 per cent higher than expected. Similarly, the Eurostoxx 600, which aggregates the financial performance of European companies recorded an earnings surprise of 32 per cent.
Moreover, earnings sentiment has started to improve. According to Factset, third quarter earnings expectations moved higher for S&P 500 companies, noting the first increase in earnings per share estimate over the first month of a quarter since 2008. While keeping in mind that earnings estimates were cut substantially during the second quarter, upward earnings revisions were particularly noted across cyclical sectors, including energy, consumer discretionary and financials sectors.
Economic data has also continued to improve over the recent weeks, with leading economic data signalling a start to a recovery, as economies exited from the extreme lockdowns experienced at the start of the pandemic. For the first time since March, initial jobless claims in the US fell below the one million level last week, and US retail sales data recovered to prior COVID-19 levels as consumer spending improved. In Europe, Purchasing Managers Indices data has so far also managed to rebound more strongly than expected during the months of May, June and July.
On the flipside however, despite that equity markets are pricing in expectations for an economic recovery and virus containment, rising concerns over recent spike in cases in Europe and the mixed COVID-19 situation across US states together with news of newly imposed restrictions remind us that the pandemic is far from over and the economic recovery is not as straightforward. What can therefore sustain the cyclical rotation is ultimately a continued improvement in economic fundamentals that paves the path to narrow the gap between current economic activity and pre-pandemic levels.
Disclaimer: This article was issued by Rachel Meilak, CFA equity analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.