Profit growth is expected to be driven by the sectors and industries that were hit hardest during the pandemic.
Global Market Strategist
At this time last year, the global economy was in the throes of the pandemic. Lockdowns had been put in place around much of the world, only grocery stores and pharmacies were open, and toilet paper was flying off the shelves. One year later, restaurants are filling up, airports are seeing more passenger traffic, and toilet paper is in stock. The reopening has arrived.
The equity market always believed we would get here, and with a little help from policymakers, began pricing in a rebound in economic activity and corporate profits before the first wave of the pandemic had run its course. In fact, from the low on March 23, 2020, the S&P 500 posted its best rolling 12-month return in more than thirty years. There was always light at the end of the tunnel; the question was how long the tunnel might be.
That light is now shining brightly, as evidenced by the first quarter earnings reports we have received thus far. In fact, as of 14th May 2021, the end of last week, with 91.3% of market capitalization reporting, we currently estimate 1Q21 S&P 500 operating earnings of USD 47.28 per share, which represents a 142.5% growth rate from a year prior. Beneath the surface, 86% of companies have beaten earnings estimates while 72% have beaten sales estimates; both of these figures, as well as the corresponding surprise data, are well above long-run averages.
Profit growth is expected to be driven by the sectors and industries that were hit hardest during the pandemic. Full-year 2021 estimates for almost 45% growth seem a bit rich—we think 35-40% is more reasonable—but the bottom line is that earnings growth will be very strong this year. However, as we look ahead to 2022, higher taxes, rising wages, and slowing revenues all look set to pressure margins, and challenge the ability for earnings to continue growing at such a rapid clip.
The outlook for 2021 earnings is quite robust, but there are risks on the horizon. Front and center is the issue of higher corporate income taxes, which are central to the Biden Administration’s proposed infrastructure package. The current proposal calls for a number of reforms, including increasing the headline corporate rate from 21% to 28%, imposing a global minimum tax of 21% on overseas income for U.S. companies, a global agreement on international taxation through the Organization for Economic Co-operation and Development, imposing a 15% minimum tax on the “book income” of the largest U.S. corporations, inhibiting inversions and encourage on-shoring and eliminating tax breaks on foreign income derived from intangible assets.
This is an ambitious plan, but seems unlikely to pass in its current form. The bill will need to be passed through the budget reconciliation process where only 51 votes are needed, and this requires broad-based support. Moderate Democrats have already said that they will support an increase in the headline corporate rate to 25%, but not 28%. By our lights, this view on tax hikes foreshadows the broader process, and suggests that the more controversial issues are unlikely to make it across the finish line.
EXHIBIT 1: EARNINGS DON’T ADJUST UNTIL TAX CHANGES BECOME LAW
From a profit perspective, an increase in the headline tax rate from 21% to 25% would reduce 2022 S&P 500 operating earnings by USD 9 to 10 per share1. This is not insignificant, but the equity market tends to take tax hikes in stride during periods of above-trend growth. But when will this start to get priced into markets? In 2017, earnings estimates didn’t adjust until the ink on the Tax Cuts and Jobs Act was nearly dry.
While the increase in taxes looks to be more benign than expected, profit margins may still come under pressure next year. Economic growth is expected to remain above trend, but will decelerate sharply from the pace observed in 2021. At the same time, as the labor market approaches full employment, wages and long-term interest rates should rise. This combination of slower revenue growth and rising costs has the potential to squeeze margins, particularly if corporations remain reluctant to pass along the increase in costs to the end-consumer. Against this backdrop, 2022 estimates for nearly 15% growth in operating earnings per share seem like a bit of a stretch.
As the economy reopens, industries and sectors hit hardest by the pandemic will rebound strongly and support the reflation trade that began last November. Although the cyclical sectors have taken a bit of a pause as long-term interest rates consolidated in recent weeks, a further steepening of the curve during the second half of this year should lead these sectors to enjoy another period of outperformance. From a micro perspective, an environment of increasingly synchronized global growth should support the industrial and material sectors, while higher rates and the ability to increase dividends and buybacks in 2H21 should lend support to financials. At some point, however, an environment of trend growth will begin to come back into focus; this will be the signal that investors may want to begin gravitating back towards higher quality, growth equities.