- The economy is coming back online, supporting a rebound in profits
- Those sectors that were hit the hardest look set to see earnings bounce strongly in 2021
- Higher corporate taxes are on the horizon, but this is not an insurmountable hurdle
- Slower revenue growth and rising costs may be an issue for margins next year
- We still prefer value to growth, but recognize the reflation trade will not last forever
Open for business
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 (Exhibit 1). There was always light at the end of the tunnel; the question was how long the tunnel might be.
Exhibit 1: The best 12-month rolling return in more than 30 years!
Rolling 12 month total returns
That light is now shining brightly, as evidenced by the first quarter earnings reports we have received thus far. In fact, with 24% of market capitalization reporting, we currently estimate 1Q21 S&P 500 operating earnings of 42.33 USD per share, which represents a 117% growth rate from a year prior. Beneath the surface, 86% of companies have beaten earnings estimates while 71% 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.
A reflationary main course
As always, the financial sector has kicked things off, and earnings are expected to rise by more than 100% on a year-over-year basis. Capital market activity and the release of loan loss reserves were key drivers of profitability, but signs of ebbing loan demand alongside net interest margins that remain under pressure were soft spots in what were otherwise very positive reports.
Consumer discretionary companies are another bright spot, as strong results in the automobile industry reflect a record number of light-vehicle sales in March (17.7 million annualized) and short-term price increases stemming from supply constraints. More broadly, profits at firms selling durable consumer goods, soft goods, and apparel all saw profits bounce nicely due to a combination of the economy reopening and fiscal support. However, this stands in sharp contrast to the consumer staples sector, where soft revenues and a decline in margins at food and staples retailers are expected to lead earnings to contract on a year-over-year basis (Exhibit 2).
Exhibit 2: Groceries are out, autos are in
y/y% change in retail sales at grocery stores and auto dealers
The technology sector continues to benefit from the pandemic, but earnings look set to slow from the torrid pace observed in 2020. That said, hardware and semiconductors are bright spots, and the average level of the US dollar index fell by 7.4% y/y during the first quarter, providing an additional tailwind for profits. In communication services, however, earnings at media and entertainment companies look to have dragged on sector profitability more broadly despite strength in internet services and home entertainment.
Turning to energy, earnings are expected to jump nearly 1000% on an operating basis due to higher oil prices and easy year-over-year comparisons. In fact, the average price of a barrel of WTI oil increased 47.8% y/y during the first quarter, which coupled with negative earnings in 1Q20, are driving these robust results. On the other hand, the industrial sector is expected to see more modest operating earnings growth of 14.5%, as airlines continue to struggle in a world where global travel remains under pressure and domestic bookings remain below 2019 levels (Exhibit 3).
Exhibit 3: More people are flying, but not as many as in 2019
7-day moving average
Finally, health care profits seem to have bucked the trend of slower earnings growth that is evident across the higher quality, less cyclical sectors. Profits at pharmaceutical and biotechnology companies remain solid, but more importantly, health care equipment and services companies have seen revenues accelerate as medical practices move away from solely treating COVID.
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 the following:
- Increase the headline corporate rate from 21% to 28%
- Impose 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 (OECD)
- Impose a 15% minimum tax on the “book income” of the largest U.S. corporations
- Inhibit inversions and encourage on-shoring
- Eliminate 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 4).
From a profit perspective, an increase in the headline tax rate from 21% to 25% would reduce 2022 S&P 500 operating earnings by 9 USD to 10 USD 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 (TCJA) was nearly dry.
Exhibit 4: Earnings don't adjust until tax changes become law
2018 S&P 500 earnings per share estimate, Dec. 2016 - Dec. 2017
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 (Exhibit 5). 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.
Exhibit 5: Analysts are too pessimistic about the near-term, too optimistic about the long-term
Average quarterly analyst over/underestimate compared to actual earnings, 1Q 2009 to 4Q 2020
As the warmer springtime weather becomes more consistent, I plan on going out to eat at the new restaurant in town. To me, it symbolizes that we are slowly but surely moving past the pandemic, and better times lie ahead. We won’t get back to normal overnight, but the direction of travel is positive – who knows, maybe another new restaurant will open up in the coming weeks.
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.