- Non-cyclical sectors slightly out performed cyclical sectors during the quarter.
- In technology, the U.S. is improving, Europe is still not strong and developing markets lag.
- The healthcare sector improved, but it is still a question mark for the second half of the year.
As the economic recovery matures, we have seen a fairly consistent pattern in quarterly earnings: estimates come down during the course of the quarter, and then beat the “lowered bar” during corporate reporting “season.” This is a normal function of both the “muddle through” economic environment and the Wall Street analyst/corporate investor relations machinery. But it is worth noting that in this quarter, the bar was lowered a little less, and the “beat,” or clearance to the bar was a bit higher. RBC Capital Markets does a good job at tracking this and puts the “lowering” at 1.5% during the current quarter versus an average of 3.6% for the last four quarters. The “beat” was 3.4% in the current quarter versus an average of 2.7% for the last four quarters.
So, nice statistics, but what actually happened? In fairly broad terms, cyclical sectors were a mixed bag, while non-cyclicals did a little better. That might not sound all that great, but it was also true that the strength seemed to line up with the bigger pockets of earnings, making the aggregate earnings number come out a bit better. Healthcare came in pretty strong, and consumer staples, while not showing much revenue growth, came in with good margin performance. Industrials were a source of disappointment, while poor old tech showed some life.
In the technology sector, second quarter spending improved moderately over the first quarter, which turned out to be down year over year in the U.S. While some of this was normal seasonal improvement, management commentary sounded more upbeat about second half demand. Still, tech growth rates remained subdued and it is hard to call an inflection. North American demand continues to steadily improve, Europe was better than expected, but still not strong; and developing markets continue to lag. IT Services industry was a particular area of weakness, with slowing demand of application installations and increased pricing pressure.
Except for a few pockets of strength, the industrial sector fell short of expectations. Activity in the quarter was on the weak side, but investors were probably more disappointed by the drumbeat of reduced guidance and projections for the second half of 2014 and for 2015. In addition, several companies reported cost headwinds, causing analysts and investors to lower expectations for profit margins.
For the big banks, the market had already digested early indications that the fixed income trading environment was quite weak for the first two months of the quarter, and thus was positively surprised to learn that June was quite strong. This reflected increased market volatility but not an increase in trading volumes, which would have signaled greater durability to the new trend. July trading commentary reverted to weak volatility and weak volumes. The other surprising trend in the quarter was a modest acceleration in loan originations, mostly corporate, though consumer also perked up, despite mortgage continuing to be weak. In general, the capital markets influenced companies beat low expectations in the second quarter.
Expectations in healthcare were for a pickup in health care utilization this quarter following a seasonally challenged first quarter. Hospital stocks saw robust profit gains ahead of expectations driven by the Affordable Care Act (ACA) and reduction of bad debts. To a lesser extent there were modest improvements in utilization, but this may have been more share driven than market driven because device stocks did not see a noticeable improvement in their results. While device stocks did not deliver against more heightened investor sales expectations, sales performance was in-line with what managements laid out with earnings meeting or beating consensus, and the profit outlook for the year was modestly improved. The key question for the sector in the second half of 2014 is whether there will be a broad improvement in utilization trends, or will it be isolated to those receiving coverage from the ACA.
In sum, companies appear to be making the most of a low-growth economy. There is certainly variance across industries and sectors, but profit margins seem to be holding up despite a cost and pricing environment that seems a bit tougher than we’ve seen over the last few years.