- Both 4Q20 and full year 2020 earnings look set to exceed expectations
- Cyclical sector earnings remain under pressure, while technology and health care earnings continue to look robust
- Margin expansion will be key for earnings growth in 2021; taxes remain a risk
- A rebounding economy and a steepening yield curve could lead value to outperform growth
A challenging climb
The silver lining of quarantine has been time spent with my young daughter. Every night we go upstairs to her room, sit in a large arm chair, and read a selection of books. One of her favorites is The Little Engine That Could. In this story, a tiny steam engine pulls a broken-down train up and over a mountain. As the tiny engine climbs the mountain, it repeats the mantra “I think I can, I think I can,” and eventually succeeds in getting up and over the hill. On the way down, the engine repeats to itself “I thought I could, I thought I could,” as it descends toward the town below1.
Similar to the little engine, investors in 2020 recognized the challenges posed by the pandemic, but believed that with patience, policy support, and a bit of optimism, they would eventually get to the other side. The final earnings reports of 2020 are now being delivered, and the investment community can shift its focus from climbing the mountain to the descent. 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 dollar, and higher oil prices should push 2021 S&P 500 operating earnings to a new all-time high (Exhibit 1).
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 twelve 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.
Exhibit 1: EPS revisions remained low in 2020
# of revision instances in the S&P 500 since 4Q10
I think I can, I think I can
The fourth quarter earnings season is underway, and with 47.2% of S&P 500 market capitalization reporting, we are tracking operating earnings of 37.83 USD per share; if realized this would represent a decline of 3.4% 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.
Unsurprisingly, low interest rates continue to be a headwind for the financial sector. Although net interest margins improved slightly on a quarter-over-quarter basis, they are still lower than a year ago. Low rates will likely weigh on net interest margins going forward, but the release of loan loss reserves helped boost profits in 4Q20 (Exhibit 2).
Exhibit 2: Net interest margins remain under pressure
U.S. banks, quarterly
On the capital markets side, investment banking results have been impressive due to record equity and debt issuance; however, this was partially offset by a slowdown in trading activity. Asset management businesses posted strong results for the quarter, primarily due to increases in AUM, higher fees, and an increase in long-term net inflows.
The industrial sector remains under pressure, and the airline industry in particular continues to struggle. In fact, some early reporters are expecting a 60-70% decline year-over-year decline in 1Q21 revenues after a difficult fourth quarter. Although corporate travel looks set to remain subdued for the foreseeable future, airlines’ cargo businesses have been boosted due to elevated demand for air freight capacity (Exhibit 3).
Exhibit 3: One-third of the global aircraft fleet is still grounded
% of global fleet parked
Earnings are expected to rise in the materials sector, driven by easy comparisons for metal and mining companies. However, chemical companies, which are the largest subgroup, should see profits decline. In the energy sector, both earnings and revenues are set to fall, reflecting average WTI oil prices that were 25% lower than a year prior, as well as softer volumes.
Health care results are expected to be solid, with current estimates pointing to year-over-year growth of 30.3%. This strength looks relatively broad-based, as biotech, medical equipment, and pharmaceutical companies are all expected to see profits increase. Health insurance companies will continue to struggle as medical utilization rates lag, but we expect some improvement as economies reopen this year.
When it comes to the consumer sectors, staples look set to see earnings rise, while discretionary companies look set to see earnings decline. Earnings growth in the consumer staples sector is expected to be positive across all groups, with household and personal products leading the charge. On the discretionary side, earnings look set to contract 20.3%, but there is significant divergence beneath the surface. Gaming, lodging and leisure names remain under significant pressure, as do clothing and apparel companies. However, auto sector earnings appear to have bounced strongly in the fourth quarter, and hardline retail has benefitted from an economic recovery that has favored goods over services. Internet retail results look set to be mixed, as strength in e-commerce is offset by weakness in travel-related services.
Finally, the technology sector should record another solid quarter of profits. This strength stems from a weaker U.S. dollar, robust activity in the semiconductor industry during the fourth quarter, and an improvement in profits at both software and hardware companies. Conversely, payment processors are expected to see earnings decline, which can be attributed to softer consumption on the back of delayed fiscal stimulus late last year. Technology sector earnings stand in contrast to the outlook for the communication services sector, where despite strength in internet services and home entertainment, profits are expected to fall on a year-over-year basis.
I thought I could, I thought I could
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. This stands in sharp contrast to the experience of the financial crisis; profit margins began to decline in 4Q06, fell to zero in 4Q08, and did not hit a new high until 4Q13.
Although margins across the board remain below prior peaks, technology and health care are close to making new highs. However, as shown in the chart below (Exhibit 4), there is considerable room for improvement in the more cyclical sectors. 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 168 USD by the end of this year.
Exhibit 4: Profit margins remain below prior peaks
S&P 500 sector operating margins, 4Q20, % of prior peak
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 9 USD hit to S&P 500 operating earnings in 20222.
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.
As the pandemic began, recency bias led investors to embrace parts of the equity market that had worked well during the prior expansion. This created a handful of winners, a fair number of losers, and pushed S&P 500 valuation dispersion to its widest range in more than 25 years.
As a result, 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. As shown in the chart below (Exhibit 5), the relative performance of value and growth tends to track the spread between the Federal Funds Rate and the 10-year U.S. Treasury yield3; 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 Fed Funds rate remains anchored at zero and long rates drift higher.
Exhibit 5: Value outperformance coincides with a steeper curve
Value/growth relative performance, 10yr - FFR spread
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.
1 Piper, Watty. The Little Engine that Could. First published 1930.
2 Assumes average earnings growth of 8% in 2022 and an effective corporate tax rate of 25%.
3 The exception is the Financial Crisis, when strength in the energy sector allowed value to outperform.