Wall Street is bracing for what could be a grim earnings season after global equities lost about $11 trillion in the third quarter. Although companies will identify this year's usual suspects --a strong dollar and weak energy prices-- as sources of weakness, there are some notable differences this time around as China’s economic growth continues to slow.
Stocks have fallen sharply heading into the third quarter earnings season, driven by fears of a China-fueled global slowdown. The S&P 500 tumbled 12 percent between July 20 and August 25 in the first stock market correction in four years.
“It has been a while since investors were as negative as they are now heading an earnings reporting season,” Burt White, chief investment officer at LPL Financial, said in a recent note. Analysts have significantly lowered their expectations, driven again by volatility in global markets due to economic slowdown in China, low energy prices and the continued strength of the U.S. dollar.
Standard & Poor's 500 earnings are forecast to have declined by 4.1 percent during the third-quarter from a year ago, according to analysts polled by Thomson Reuters. If this erosion materializes in this season's financial reports, the decline will be the second in a row and the first back-to-back decline since 2009.
The overall estimates are skewed, however, by an expected 65 percent fall in energy sector results. Non-energy companies may have grown earnings by 10 percent during the third quarter, excluding the impact of currency fluctuations on profits earned overseas, according to LPL Financial. “That’s pretty good underlying earnings power and speaks to the health of the broader U.S. economy,” White explained.
Experts are also looking for evidence of whether stresses on financial markets will have deeper impact on U.S. hiring activity and consumer sentiment. "If you see the domestic story start to fade, that would be disappointing news," Jeremy Lawson, chief economist of Standard Life Investments, said.
Here's a fresh look at three themes to watch this earnings season:
The slowdown of the world's second largest economy is one of the major differences between this quarter and last. Although the country accounts for less than 5 percent of S&P 500 profits, it is responsible for much of the weakness in commodity sector earnings.
China is in the midst of a shifting away from an export driven economy to a consumer driven economy to rely more on internal sources of growth. But the economy is also dealing with a slowdown in credit growth after a period of rapid expansion before the global financial crisis.
"What we’re seeing at the moment is rather than China being a propelling force for the global economy, it’s a contracting force," Lawson said. Even if China isn’t in a recession, the changing composition of its growth and the reduction of imports means the slowdown is leading to recessionary conditions outside of the region, particularly commodity exporters in Latin America, Lawson explained.
Meanwhile, China is also the world's largest consumer of most commodities. Market professionals will be listening in on what companies are saying about Chinese demand. The precipitous drop in commodity prices, weighing on the energy, industrial and material sectors, has also has weighed on industrial metals.
“Global weakness for certain metals such as aluminum and steel have also made matters worse in China as they are the biggest exporter of those metals,” research firm Estimize said in a report.
2. Declining Oil Prices
The oil industry is expected to continue suffering --after losing nearly half of its value over the last year. Weakness in the energy sector is expected to remain, with profits anticipated to decline 66 percent and revenues down 30 percent from a year ago, according to research firm Estimize.
West Texas Intermediate crude, the benchmark for U.S. oil prices, has dipped more than 40 percent in the last year, recently trading around $49 a barrel on the New York Mercantile Exchange. On the London ICE Futures Exchange, Brent crude, the global benchmark for oil prices, has lost 44 percent in the last 12 months, now trading around $50 a barrel.
There are some bright spots, however. The consumer discretionary sector is likely to be one of the top performing third quarter sectors, due to cheaper gas prices. With relatively less overseas exposure, the sector is somewhat insulated from the slowdown in China.
3. Currency Issues Remain
A stronger U.S. dollar isn't exactly good news for U.S. corporations. Another major theme this earnings season will be the strengthening dollar's effect on the revenue and profits of multinationals. The robust dollar weighs heavily on growth for the benchmark S&P 500, for instance, since the index’s companies derive more than 40 percent their revenue overseas.
As the U.S. economy steadily improves, the value of the dollar continues to advance against major currencies. The greenback has gained around 5 percent against major world currencies since January and more than 11 percent in the last year.
A prolonged period of dollar strengthening hurts U.S. multinational corporations when they convert foreign revenue to dollars, thereby slowing earnings growth. Some companies will feel the pain more than others. Almost 83 percent of Intel Corp. sales, for instance, come from overseas, while Qualcomm Inc.’s international sales account for 97 percent of its annual revenue.