Banks unofficially kick off corporate reporting next week and investors are watching to see if corporate America fell into its first earnings recession in three years in the second quarter amid slowing growth and ongoing trade woes.

Here’s what to watch for:

Bottom-line

With analysts predicting an earnings recession — defined as two consecutive quarters of year-on-year earnings declines — for the first time since 2016, the bottom line grabs the limelight once again.

S&P 500 companies are estimated to report an earnings fall of 2.8 per cent in the second quarter, according to data provider FactSet, following a 0.3 per cent slide in the first three months of the year.

Separately, it is worth noting, small-cap companies, those with a market capitalisation between $300m and $2bn and represented by the S&P 600, are set to fare worse than their blue-chip counterparts and report a 12 per cent EPS drop, though still an improvement on the 17 per cent fall in the first quarter, analysts at Bank of America said. Meanwhile, mid-caps are expected to report a 5 per cent year-on-year earnings fall, a modest improvement on the first three months of the year.

While analysts have been predicting an earnings recession since late last year as incoming data deteriorated, not everyone is expecting one. Patrick Palfrey, strategist at Credit Suisse, said “people have over extrapolated the deceleration in the data too far”. He expects earnings to turn up positive when including the impact of share buybacks and factoring in the historical beat rate.

Buybacks

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That brings us to share repurchases, a divisive practice that is accused, among other things, of propping up earnings by reducing the overall share count and thereby spreading out profits over a smaller portion of shares.

At a time of somewhat anaemic economic growth, buybacks are helping boost earnings. Net share buybacks are expected to contribute 2.1 per cent to earnings per share growth in the second quarter, according to analysts at Credit Suisse — that is about the same contribution as the year-ago period.

US companies snapped up more than $1tn of their own stock last year, a record figure, driven by the tax overhaul, and the practice has drawn the ire of some Democrats, who have argued against what they call “corporate self-indulgence” and are looking to limit repurchases.

Margins

Higher wages, rising input costs and strength in the US dollar are predicted to contribute to margin pressures, despite expected top-line growth. S&P 500 companies are forecast to report a 3.7 per cent increase in revenues, which would be the weakest growth since the third quarter of 2016.

Analysts expect non-financial companies to report net margins of 10.8 per cent in the second quarter, down from 11.5 per cent in the year-ago quarter, according to figures cited by Bank of America analysts.

“We have been highlighting risk to margins from rising input costs for companies that don’t have pricing power, as well as for labour-intensive companies/sectors amid rising wages, and we expect full-year net margins to contract to 11.2% in 2019 ex-financials from 11.7% in 2018,” they add.

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Other social media names however are faced with issues unique to them, for instance investments in security and other product developments are exerting short-term pressures on social media companies like Facebook and Alphabet.

Sector breakdown

Materials, the sector with the most sensitivity to China and the fallout from the ongoing trade war between Washington and Beijing, is expected to have had the toughest time in the second quarter. DuPont and Freeport-McMoRan are expected to be the biggest contributors to the sector’s earnings slump, according to FactSet. The sector is projected to report a 16 per cent year-on-year decline in earnings and a 14.9 per cent drop in revenues.

Tech is in close competition in this particular race to the bottom, with expectations for an 11.9 per cent fall in earnings and a 1.1 per cent drop in revenues.

Given the uncertain geopolitical backdrop and softening economic data, it should come as no surprise that defensive sectors like utilities and healthcare are projected to report the strongest earnings growth of 2.2 per cent and 2.1 per cent respectively.

Earnings call

Some of the juiciest news is reserved for a company’s earnings call, whether that be a change in strategy or management’s outlook on industry or broader macro trends.

Washington’s multi-fronted trade war, but particularly its spat with China — a crucial part of many companies’ supply chains and a key market for certain industries — is one subject America’s C-suite is expected to address. Both sides have hiked tariffs on billions of dollars of goods, and the trade war has been partly blamed for weakening the economic outlook.

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Uncertainty about the ongoing trade war and its impact on business’ spending plans and supply chains is a subject investors will play close attention to.

Any commentary on strength in the US dollar, which makes American goods more expensive to foreign buyers and hurts earnings upon conversion, will also be closely watched.

Investors may also be treated to commentary on the Federal Reserve, which has adopted a dovish stance, and the impact its monetary policy could have on capital expenditure.



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