The final earnings reports of 2020 are now being delivered, and S&P 500 operating earnings appear to have fallen by about 20% in 2020, far better than the 31% decline that was projected at the end of the second quarter. Looking ahead, a more favorable starting point, robust economic growth, a weaker U.S. dollar, and higher oil prices should push 2021 S&P 500 operating earnings to a new all-time high.
Questions remain about the evolution of monetary and fiscal policy, higher taxes, vaccine distribution, and virus mutation. In general, however, a backdrop characterized by improving growth and easy policy should support U.S. equity performance over the next 12 months. There will be periods of volatility, but we do not expect a repeat of early 2020. One of the things that roiled markets at the beginning of last year was a lack of information about the pandemic, and specifically, its impact on corporate profits. However, corporate guidance in the form of earnings revisions started to return into year-end; if this trend continues, it should afford investors more clarity on profits in 2021.
The fourth quarter earnings season is underway, and as of writing, 76.5% of S&P 500 market capitalization has reported in. We are tracking operating earnings of USD 35.2 per share; if realized, this would represent an ex-energy decline of 3.6% from a year prior. So far, 84% of companies have beaten earnings estimates, while 71% of companies have beaten revenue estimates, continuing the trend of better-than-expected results that began in the second quarter.
One of the remarkable things about 2020 was the speed with which earnings rebounded during the second half of the year. This was primarily a function of profit margins; sectors like technology, health care and consumer staples saw resiliency in margins as they aggressively cut costs in the face of slowing economic growth. On the other hand, companies in the more cyclical sectors saw margins decline sharply, but then bounce strongly, as revenues rebounded and costs were contained.
It seems reasonable to expect that the combination of additional stimulus and a rebound in economic growth will allow for margin expansion, pushing earnings to a new all-time high of USD 168 by the end of this year. However, there are two risks on the horizon. The first is higher taxes. It is not entirely clear whether Congress will increase corporate tax rates this year, but we recognize that it is on the Administration’s agenda. An increase in the corporate tax rate to 28% would weigh on margins and overall profitability; assuming this occurs next year, it would be reasonable to expect a USD 9 hit to S&P 500 operating earnings in 2022.
The second risk relates to the evolution of the economic environment. As the rebound fades and we return to trend growth, economic activity will slow and wages will rise. This will weigh on revenues and boost costs, pushing profit margins lower.
EXHIBIT 1: SPREADS SUGGEST VALUE WILL OUTPERFORM GROWTH
2021 is a year to be active. We forecast an environment of accelerating economic activity and rising interest rates, which should support the more cyclical and value-oriented sectors of the market. Of course, given the solid outperformance of these cyclical names over the past few months, many investors are asking if this trade has run its course.
Our answer would be no. The relative performance of value and growth tends to track the spread between the Federal Funds Rate and the 10-year U.S. Treasury yield (except during the financial crisis, when strength in the energy sector allowed value to outperform); although the curve has steepened as of late, value has only begun to catch up relative to growth. Furthermore, the Federal Reserve has been quite clear that policy normalization will be a process that starts with the tapering of asset purchases and gradually extends to raising rates. This points to a steeper curve as the Federal Funds rate remains anchored at zero and long rates drift higher.
For years, investors have been looking for value to outperform growth, citing attractive relative valuations. While we acknowledge that value remains cheap relative to growth, this is only one piece of the story; the key is to identify assets that are attractively priced and look set to outperform in the expected macro environment. Value has historically outperformed growth during periods of accelerating economic activity and a steeper yield curve; as such, it will be important for investors to have sufficient value exposure in portfolios during the coming year.