Mark Lister, 13 April 2016

The quarterly reporting season in the US ramps up over the next couple of weeks, and with forecasts suggesting it will be the weakest in almost seven years, markets face an important test.

Shares prices, oil and higher risk currencies have rebounded strongly over the past two months, as the worries that dominated headlines in January have faded away. With some markets back in positive territory for 2016, and within striking distance of last year’s record highs, the next month or so could be interesting.

A handful of companies are scheduled to report results this week, before things really heat up during the second half of April.

Earnings expectations have fallen sharply, with analysts slashing their forecasts by close to 10 per cent over the past three months. The S&P500 index is now forecast to see earnings decline by more than 8 per cent, well down from the small gain that was expected at the beginning of the year.

This would make for the third consecutive quarter of falling earnings, and the worst performance in this regard since March 2009. Seven of the 10 main industry sectors are forecast to see earnings go down, rather than up.

Unsurprisingly, it is the energy sector which is to blame for the bulk of this weakness. With oil prices so much lower than they were a year ago, profits will be substantially lower this quarter. However, even when energy is excluded earnings are expected to decline about 3 per cent, and forecasts have still come down almost 7 per cent this year.

There are a few reasons why profits are slipping. For a start, the global economy has hit a soft patch in recent months, the US included. While it is still in generally good shape, GDP growth in the first quarter is likely to be pretty much flat. This is keeping revenue growth subdued for many corporates, while profit margins have been declining as they run out of cost-cutting opportunities.

Labour costs have been quietly increasing as the jobs market tightens, so the bright spot of the US economy has ironically started becoming problematic for Wall Street.

The US dollar has also been stronger than previous years, creating headwinds for multinationals that do business internationally.

Against the backdrop of a gloomy reporting season, it’s easy to be cynical about the strength of the recent rebound.

US shares were down 10.5 per cent year-to-date at one point in February, but have rallied strongly since then, erasing all of those losses to be just a few percentage points away from their May 2015 peak. Similarly, oil has rallied 45 per cent since languishing at US$27 two months ago.

If current earnings forecasts are accurate, a tepid reporting season could be a catalyst for some of these recent gains to unwind and for markets to sell off a little. If expectations turn out to be too pessimistic, we could see a relief rally in some sectors and companies.

I’m leaning a little toward the former, but either way it will make for an interesting few weeks.

This article originally appeared in the New Zealand Herald on 13 April 2016