Why Brexit could throw a monkey wrench into Q3 and Q4 earnings

Traders work on the floor of the New York Stock Exchange.
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Traders work on the floor of the New York Stock Exchange.

What will be the Brexit vote's impact on third-quarter earnings?

The question is easy to frame but difficult to answer. Will Brexit be a long-term market-moving event or a short-term phenomenon? Will it prove as big a problem for the markets as, say, China's currency devaluation in August, or the oil collapse that roiled markets in the first quarter of this year?

So far, the impact on the U.S. is modest: a little more than 2 percent drop in the S&P 500. The dollar has stopped rising, bond yields have stopped dropping, and oil has turned higher.

This is not over, however, and unfortunately the Brexit issue has come at a bad time for U.S. earnings.

Simply put, Brexit may torpedo any chance of a return to positive earnings growth for the S&P 500 for the year.

As we begin the third quarter, earnings for the S&P 500 are facing five consecutive quarters of negative earnings growth — an earnings recession not seen since 2008 to 2009.

Analysts have modeled an end to the negative earnings growth for the third quarter, and particularly in the final quarter of 2016, with overall earnings expected to grow 1.4 percent in Q3 and 7.5 percent for Q4, according to Factset.

Brexit may throw a monkey wrench into that analysis. Let's just look at a few sectors and see what could go wrong.

1) Materials are expected to report big gains, up 8.5 percent for the third quarter and 13.8 percent for the entire second half.

The problem: If the dollar rally continues on a flight-to-safety play, forget about it. We saw 10 percent drops in big materials names like Freeport McMoran in the first two days after the Brexit vote. They have recovered only because the dollar has stabilized.

Dollar strength is not just a problem for materials. The three sectors with the highest international exposure are technology, materials, and energy, so all of them would have big issues should the dollar surge again.

2) Financials are expected to have growth of 5.1 percent for the third quarter, and a whopping 19 percent in the fourth quarter. Goldman Sachs is expected to be one of the largest contributors in the second half of the year — its earnings for the third quarter and fourth quarter are expected to double, from $4.17 a share to $8.56 a share. Insurance companies are expected to see earnings grow 41 percent in the second half.

The problem: If there are any macro effects from Brexit, Goldman will certainly feel it. This could include something as simple as a slowdown in business activity, such as mergers and acquisitions or trading, but it could be even bigger. For example, the lower-for-longer scenario is going to put pressure on bank earnings in general. Other firms that depend on rate hikes like retail brokerages will also take a hit.

And remember, with the euro down and the dollar higher, global banks with significant exposure overseas will also take a hit to earnings. Twenty-five percent of Goldman Sachs revenue comes from Europe, the Middle East, and Africa.

It's not all bad news. For example, look at energy. The good news is the comparisons start getting really easy for energy in the fourth quarter. Of course, the gains are also based on higher oil prices, which may or may not materialize.

And consumer discretionary is expected to report a growth rate of 9 percent, the highest of any sector in the third quarter. This may have a shot, because Amazon will be the largest contributor. It is looking for earnings of 98 cents a share, a huge increase from the 17 cents reported in the third quarter of 2015. It has a very good chance at hitting that number.

But overall, with financials such a huge part of the S&P and the dollar impacting so many sectors, risk is definitely to the downside.

There's one final point. The analysts have been very optimistic about a second-half recovery in the last few years, and have been wrong. Over the last five years, according to Factset, analysts have overestimated the actual earnings growth for the second half of the same year by nearly 4.7 percentage points. If that holds true this year, the estimated growth rate of 4.2 percent for the second half of 2016 would come in at a decline of 0.5 percent.

See what I mean? A lot has to go right for us to get out of this earnings recession.

  • Bob Pisani

    A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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