What investors should focus on heading into Q3 earnings season

John Lynch, Comerica Wealth Management CIO, joins Yahoo Finance to discuss the outlook on the upcoming earnings season and moves in the bond market.

Video transcript

ALEXIS CHRISTOFOROUS: All right, want to get back to the big business news of the week, really, which is third quarter earnings season going to start ramping up. We're going to hear from some of the big banks in the coming days. And to help us break it all down is John Lynch, Comerica Wealth Management CIO.

John, good to have you here on the show. So, look, the thing for me that's different about this earnings season, it's the first time in about four quarters where the Street is actually bumping down its estimates for these corporate earnings reports. What are your expectations from corporate America?

JOHN LYNCH: Well, good afternoon, Alexis. And thank you for having me on. I'm still looking for 30% earnings growth for the third quarter on a year over year basis. And you're right, the last couple of three weeks, we've start to seen analysts reduce expectations. But be mindful that companies typically beat by about 3% or 4% when you look at the index level.

I think what's fascinating is that this could be the third best quarter of the past decade. Yet it's seemingly inconsequential. It's a tough act to follow after earnings were up 90% in the second quarter. So the message I'm giving to our investors is that focus not necessarily on what the third quarter print is, but more important, focus on what companies are saying about visibility going forward. And we think we're going to see good visibility from some of the value and cyclical players going forward.

ALEXIS CHRISTOFOROUS: How do you see, though, John, all the supply chain disruptions playing into earnings season when companies start to give those projections? Are they going to say that margins are squeezed because of the extra costs they've had to take on with all of the supply chain disruptions?

JOHN LYNCH: I think you'll definitely see that for the third quarter. And going forward, that's why I think the comments from the CEOs and the CFOs will be so important because-- you use the term "margins being squeezed." And margins have been at a record level, 13%, and they'll probably go to 12% for this current quarter. And even if they go to 9% or 10%-- you know, I remember a day-- it wasn't too long ago-- when 7% or 8% was a pretty good margin. And it's just fascinating how, you know, the perception of that changes.

So, whether it's supply chain disruption, whether it's T&Ts, as I call it, taper and taxes, market interest rates rising next year, that'll cost, you know, interest expense to escalate, you know, the potential corporate tax rate at 26%. I think we need to be prepared for 10% ish, 9% ish type margins for 2022 and 2023. Certainly down from 12% or 13%, but still a pretty good number going forward.

ALEXIS CHRISTOFOROUS: Yeah, that gives us some perspective. Those are still pretty healthy margins to be putting up. So what are you doing in terms of client portfolios as you position for this earnings season, and then looking ahead to the next earnings season, even?

JOHN LYNCH: Well, we've been positioned cyclically, which seemed like a great call in the first four months of the year. And then I think the market just got real scared about the delta variant. And we saw the-- it was almost like when the market was preparing for inflation, cyclicals are doing well. And once inflation hit, the 10-year, as you know, went from, what, 1.75 to a 1.15 yield on the 10-year Treasury.

Now that the 10-year yield is probably hovering around 1.58, 1.59 today, we're still sticking with the cyclical call. Slight overweights to value relative to the growth, slight overweights. Again, value relative to growth, small relative to large, and certainly emphasizing some of the materials, energy, industrial, financial names. Really, very much unlike what's leadership today.

Today is really a non-conviction day, looking at REITs and staples and utilities leading. The only cyclical that's leading there is consumer discretionary. But we're only looking at maybe 4% or 5% earnings growth from that group in the third quarter. So I don't know if that's really going to be a driver.

ALEXIS CHRISTOFOROUS: I'm really glad you brought up the bond market because I wanted to bring that up as well. We know that stock prices have been pressured by rising rates in the bond market, as investors there start to position themselves ahead of the Federal Reserve, beginning to taper. As you said, that yield on the 10-year now at 1.58%. But should investors be as worried as they seem to be about these higher rates? Because 1.58% is still relatively low.

JOHN LYNCH: Still, yeah, that's exactly right. If you think about since World War II, the 10-years averaged, what, 6 and 3/4 or something like that. So we still are at a 500 [INAUDIBLE] to that number, so. And I think that's important for factoring in the equity valuation. You know, from a fixed income standpoint, we want to keep interest rate sensitivity or duration low. We want to keep credit quality high. Rates-- market interest rates are nudging higher. And we look for that to continue. But perspective is key.

You know, the Fed-- I think tapering is within months. But it's conceivable that an actual Fed rate increase, an increase in the federal funds rate, it may not occur in 2022. It could be a couple of years away. If tapering is a couple of months, rate increase could be a couple of years away. And you have to think about the interest rate differentials, say, between our benchmark and, you know, the German Bund, for example. It may be negative 10 basis points today. And that's recovered from negative 50 basis points. But you still have about a 175 basis point spread.

And I know it's not in their mandate, but the Fed does need to be mindful of interest rate differentials. You know, $15 trillion in negative yielding debt, the interest expense on $22 trillion in US debt. If you look at a 100 basis point move higher, that's an additional $220 billion in financing costs. So there are a lot of factors playing in. It's conceivable the Fed's more dovish next year, particularly with some of the potential changes in leadership at the Fed.

ALEXIS CHRISTOFOROUS: All right, well, that is certainly a lot to look forward to. There's going to be a lot of movement coming out of the Federal Reserve in the coming months. John Lynch of Comerica Wealth Management, thanks so much for being with us.