Wrong mix of volatility and downgrades

As US presidential elections near (mail votes start this week) and Trump feels under increased pressure so this multiplies silly postures (vaccine calendar, TikTok, WeChat, BLM), the common view is that volatility is set to rise. It has not so far with the implied variety (Vix) remaining at a reasonable 26. As a reminder, before COVID-19, the Vix stood at 12 or so, but was regarded as unsustainably low. 

Obviously, swamping markets with money brings down implied volatility as option writers do get a sense of safety/extra duration. That means that the Vix falls in tandem with rising equity multiples. The following chart makes this point for European equities. For good measure, we excluded European banks which have been dragging down P/Es and thus kept the lead on the reality of dearness. The going price for 2020 ex Banks is 26x and close to 18x for 2021. This is not cheap.

European P/Es ex-Banks vs. Vix (in pink)

The rising 2020 P/E implies that EPSs are not going up in tandem with share prices, while the plateauing blue P/E curve (2021) shows that the missing 2020 earnings are shifted to 2021. The obvious issue is whether this will happen at all. The divide remains between bulls betting on new business models making the difference in equity indices and bears (whom we belong to) who cannot see how the real world of unemployment will not come back with a vengeance to bring down consumption and FCF generation as a result.

As we mentioned in earlier similar short views, the bull case on the earnings front remains an elusive one. Here is a table which pretty much allows for H1 20 earnings signals. Were it not for Banks, that we upgraded from admittedly too low expectations, earnings have been trimmed for both 2020 and 2021 over the last three months.

Earnings trend: no real uptick

The above table will show that over the last three months, total 2021 earnings have been upgraded by €15.7bn to €517bn but, once the Banks upgrade of €17bn is set aside, there has actually been a downgrade of €1bn to the expected ex Banks earnings in 2021. The ex Banks picture is worse (another €34.4bn downgrade over the last three months) as 24 sectors out of 29 are being trimmed. Pharmas alone account for a €10bn in this €34bn 3-month downgrade. 

Of course, superbulls will argue that the pace of downgrades is slowing down, heralding a bottoming out of the process. This is akin to buying the third derivative in earnings trends which is a bit early in such an unprecedented shock.

In short it takes a big heart to expect the 48% earnings rise in 2021 (after a 40% drop in 2020) to stick while confidence may suffer from Trump’s shenanigans to cling to power. Not a great recipe for healthy equities.