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Europe Debt Woes Cast Shadow on Earnings—and Market

With Europe’s debt woes casting a long shadow, stocks in the coming week could be vulnerable to the impact of slowing global growth on corporate America and the U.S. economy.

Euro Casts Long Shadow
John Knill | Stockbyte | Getty Images
Euro Casts Long Shadow

Earnings from more than a quarter of the S&P 500 and the first look at second-quarter GDP could be key for the market, which benefited in the past week from the idea of more Fed easing. At the same time, worries about Europe returned at the end of the week as the euro sank and Spanish bond yields shot to record highs amid worries that Spain, itself, may need a bailout.

Early in the coming week, flash PMI data is expected for China and Europe, which should show how well manufacturing activity is holding up. Analysts are watching to see if there are any signs China’s slowdown is bottoming.

Friday’s U.S. GDP report, expected by economists to show 1.5 percent growth for the second quarter, could have a major impact on sentiment, even though it is a backward looking indicator.

“The second-quarter GDP report could be the whack across the forehead that things are really slowing here,” said Barry Knapp, head of U.S. equity portfolio strategy at Barclays. If the number is weaker than expected, Knapp said it could be troublesome for stocks.

“The market is going to start thinking about the risk of recession,” he said. “We don’t think we’re going to get one. That’s not our forecast, but if the market starts to price in a higher risk of recession, that’s a negative market event.”

Earnings Central

Knapp and other analysts said earnings could start to be a negative factor for stocks because of the high number of misses on the top line.

“If you look at earnings season closely, 40 percent of the companies are beating on the revenue side,” said Knapp. “This is the worst performance since the recession. Earnings growth is slowing, and revenue growth is slowing.”

So far, of the 116 S&P 500 companies that had reported as of Friday morning, 67 percent had better-than-expected earnings, but 57 percent missed on revenue forecasts, according to Thomson Reuters. Earnings are expected to be up 5.9 percent for the quarter, based on the reports. Revenues, on average, are up 2.8 percent for the quarter. Some companies, like IBM, blamed currency fluctuation for top line hits.

“Revenue misses associated with currency rarely flow to the bottom line,” said J.P. Morgan chief equity strategist Thomas Lee. He said the costs associated with overseas operations could also drop, and that helps.

“With a pretty surprising downturn in Europe, June was definitely a leg down for a lot of companies, and China remains weak, and because there’s been such a downturn in commodities and companies have been reluctant to hire, that’s helped them beat on margins,” said Lee. “You’re quelling some of the “margins are peaking” story, because margins are expanding this quarter. You’re going to need accelerating growth next year to make up for the loss of revenue.”

Knapp said the market in 13 of the last 14 quarters has performed well for the first two weeks of the earnings season, before turning lower. Alcoa is always the first of the Dow 30 to report, and it’s earnings release is the unofficial start of the earnings reporting season. “We think part of the reason is the highest quality ones go first,” he said.

The Dow in the past week was up 0.4 percent at 12,822, and the S&P was up the same, at 1362. The Nasdaq gained 0.6 percent to 2925. Friday’s steep losses, however, wiped out the month’s gains for both the Dow and Nasdaq.

“We had two ugly Augusts, and I think this probably will be a third,” said Knapp. “That could set us up for a decent rally, but that’s putting the cart before the horse.”

Lee, on the other hand, thinks investors are too negative. “I still think investors are viewing the economy today through a lens that I think is distorted. They think the economy can be tipped into recession by any little thing,” he said. “…I just think we may have a more durable expansion and that’s simply because companies have stayed so cautions that they’re not going to get caught over their skis.”

He said housing is looking to be one of the brighter spots in the economy, and further turnaround there would be a positive.

Euro Zoned

As worries about Spainswirled, financials were the worst performers Friday, down 1.5 percent. They were also the worst performers for the week, down 2.4 percent. The euro fell one percent against the dollar Friday, and Spain’s 10-year was yielding a record 7.27 percent, a level that raises concerns about the country’s ability to fund itself. Spain this past week announced an austerity plan and tax increase. The debt-laden Valencia region Friday asked for financial aid, spurring fears that the Spanish government itself will need a bailout.

The euro zone deal to bail out Spain’s banks was also a source of concern, as it left the debt on Spain’s balance sheet. “It will increase Spanish debt,” said Alan Ruskin, G-10 currency strategist at Deutsche Bank.

“I think yield levels again are capturing attention. It’s becoming that much harder to ignore. Now that we’re trading above 7 percent, there’s a sense of how long can this go on,” he said. “Inevitably when (rates) break new ground it does get more attention.” Yields on Spain’s shorter duration debt also moved higher, with the 2-year nearing 6 percent and the 5-year nearing 7 percent.

Banks will stay a focus in the coming week, when the House Financial Services Committee hears testimony Wednesday from Treasury Secretary Tim Geithner on banking regulation, but also on the Libor rigging scandal. Barclays settled charges with U.S. and U.K. regulators that its traders rigged Libor for several years, and other banks are under investigation.

Geithner, as president of the New York Federal Reserve in 2008, had sent a letter to U.K. regulators, voicing concerns about the way Libor is set. Libor is the London Interbank Offered Rate, and is set by the banking industry.

Oil Drill

Energy stocks in the past week were the best performers, up 2.6 percent, rising with oil prices. Oil futures climbed as tensions increased between Iran and Israel, and Syria’s regime appeared like it could soon be toppled. WTI crude on the Nymex gained 5 percent to $91.44 per barrel, and Brent was up 5.3 percent at $106.83. RBOB gasoline futures gained, rising 4.5 percent to 2.9430 per gallon.

Lee said he is recommending investors move into energy stocks, which he says has been having a stealth rally.

“I think in the short-term, it seems like it’s one that could catch people by surprise. Part of it is the group has underperformed so badly,” Lee said. “Integrated companies are discounting $80 Brent crude, but Brent is at $107.”

Gasoline at the pump also rose in the past week to a national average of $3.44 per gallon, from $3.38 a week ago, according to AAA.

Analysts have been looking at the decline in gasoline as a positive for the economy, but gasoline started to reverse in late June and it could stay elevated for the rest of the summer.

The drought across the Midwest is affecting the price of ethanol, a component of gasoline, and it is a factor in the price gains, which are also driven by higher crude. Ethanol is made from corn, up more than 40 percent in the past month, and more than 7 percent in the past week. Other grains also gained, with soy beans up more than 8 percent, and wheat up 11 percent.

What to Watch

Monday

Earnings: McDonald’s, Halliburton, Hasbro, Eaton, Baidu, Celanese, Phillips Electronics, Texas Instruments, VMWare, Baidu

0700 pm Federal Reserve Gov. Sarah Raskin speaks in Colorado on community banking

Tuesday

Earnings: Apple, AT&T, DuPont, UPS, Lockheed Martin, SAP, Biogen Idec, Peabody Energy, UnderArmour, Whirlpool, Illinois Toolworks, Panera, Range Resources, Aflac, Broadcom, Cabot Oil, Norfolk Southern, Netflix, Aflac, Buffalo Wild Wings

0845 am Fed Chairman Ben Bernanke speaks about early childhood education at Children’s Defense Fund conference

1000 am Richmond Fed

1000 am FHFA home prices

0100 pm $35 billion 2-year note auction

Wednesday

Earnings: Boeing, Ford, Caterpillar, Pepsico, General Dynamics, Northrop Grumman, ConocoPhillips, Visa, Whole Foods, Owens Illinois, Akamai, Nasdaq OMX, Airgas, Wyndham World, WellPoint, GlaxoSmithkline, Bristol-Myers Squibb, Crocs, Zynga, Shutterfly, Arch Coal, Cheesecake Factory, Tupperware, US Airways, JetBlue, Motorola Solutions, Southern Co

0700 am Mortgage applications

1000 am New home sales

0100 pm $35 billion 5-year note auction

Thursday

Earnings: Exxon Mobil, Facebook, Amazon.com, MMM, United Technologies, Starbucks, Banco Santander, CME Group, Credit Suisse, Dow Chemical, Colgate-Palmolive, Kimberly Clark, Hershey, International Paper, AstraZeneca, Siemens, Unilever, Occidental Petroleum, Raytheon, Starwood, Moody’s, Potash, Sprint Nextel, Waste Management, McKesson, Chubb, Expedia, Taubman Centers

0830 am Durable goods

0830 am Jobless claims

1000 am Pending home sales

0100 pm $29 billion 7-year note auction

Friday

Earnings: Chevron, KKR, Merck, Barclays, Newmont Mining, Total, Weyerhaeuser, Helmerich and Payne, Calpine, DR Horton, Legg Mason, Newell Rubbermaid

0830 am Q2 GDP

0955 am Consumer sentiment

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Follow Patti Domm on Twitter: @pattidomm

Questions? Comments? Email us at marketinsider@cnbc.com

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    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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