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FIVE EARNINGS SEASON TAKEAWAYS
GUEST BLOG / By Angelo Kourkafas, CFA, Investment Strategist, Edward Jones Co.-- Inflation fears subsided some last week, and the S&P 500 eked out a small gain in May, its fourth consecutive monthly rise.
With few narrative-changing developments and the first-quarter earnings season largely complete, it is a good opportunity to conduct a gauge check on the health of the corporate sector. With most investors getting exposure to the stock market via mutual funds and ETFs that track major indexes, it is easy to forget that individual companies make up the market's backbone, and their collective earnings are the ones that drive investment returns over the long run.
Below we provide five takeaways from the latest earnings season and debate what recent trends imply for the future.
1. Earnings rebound gains steam
• With 97% of the S&P 500 companies having already reported results, first-quarter earnings are set to rise by 50% from a year ago, the fastest pace since 20101. Not only have a larger share of companies topped projections (86% vs 74% historically), but actual results have also exceeded analyst estimates by a record 23%. As a result, analysts have continued to revise their numbers higher, with 2021 earnings now expected to grow 34% from 22% at the start of the year.
• Unlike the previous three quarters when the better-than-projected results were primarily a function of low expectations, the fast-rising first-quarter earnings reflect broad economic strength. Demand is snapping back at a rapid pace as inflections decline, vaccinations rise, and restrictions are lifted. And as last week's income and spending data showed, consumers continue to have a significant amount of excess savings that they could deploy as normal activities begin to resume.
• In this context, the stock-market and corporate-earnings performance are in sync, which should provide some comfort to investors. But since forward 12-month corporate earnings are already expected to exceed their pre-pandemic level by +11%, is there still any room to grow? Based on our expectations for a durable expansion, we believe so. Following the last two recessions, corporate earnings continued to grow by an average of 65% once they reclaimed their prior peak.
2. Profit margins reach new record
• Revenue growth handily exceeded expectations, but it was the surge in profit margins (how profitable companies are based on the revenue they earn) to a new record high that was the standout, in our view. The biggest improvement in margins took place in the consumer discretionary (led by automakers), financials and materials sectors.
• We attribute the strong recovery in profitability to the following:
a. the benefit of rising sales driven by pent-up demand and government-income transfers;
b. productivity gains with increased tech adoption and a lag in the pace of hiring;
c. lower interest expense as companies took advantage of the record low rates;
d. smaller credit losses than feared, benefiting bank earnings as reserves get released; and
e. a lower U.S. dollar, which helps earnings of multinational companies.
• Higher input costs and material shortages likely pose near-term challenges to profitability. However, companies appear willing and able to pass these cost increases through to consumers. Historically, corporate profit margins have generally expanded with inflation. If demand stays strong as we expect, interest rates remain relatively low, and productivity rises in line with wage growth, margins can stay elevated for a while. However, this dynamic could potentially shift in late 2022 if borrowing costs rise as the expansion advances, and if wage growth accelerates as the employment slack is eliminated.
The graph above shows S&P 500 profit margins, which reached a record high in the first quarter of 2021.
3. Cyclical sectors have earnings push at their back
• Tech and growth companies continue to post stellar results even as some of the pandemic trends are starting to reverse. Yet, the biggest positive earnings surprises in first-quarter results came from cyclical sectors and value-style investments, including energy and financials, which are the top-two-performing sectors so far this year.
• Cyclical companies are very sensitive to economic growth, and for this reason, they stand to benefit more from the pickup in economic activity. With the U.S. projected to experience the fastest GDP growth this year since 1984, the case for paying-up for companies that carry high valuations but have a promising long-term growth profile becomes less compelling in the near term. Of course, that would change if the economic expansion disappoints, or Fed intervention short-circuits the recovery. But such scenarios are not the most likely over the next two years, in our view.
4. International earnings trying to catch up
• Because the vaccine rollout started more slowly in Europe and Japan, and fiscal support was not anywhere near as generous as in the U.S., the economic recovery in these regions has lagged. This is also reflected in the less robust corporate results in previous quarters. International developed-market earnings are expected to be 4% below their January 2020 level one year from now, while U.S. earnings are projected be 11% above.
• The flip side is that international markets have catch-up potential, and the first-quarter earnings results might have provided a glimpse of that. International earnings growth outpaced U.S. growth by 20%, marking the first relative outperformance in 12 quarters. Easier comparisons (profits declined more last year) and the sector makeup of international developed indexes (larger weight in cyclical sectors) argue for the improved performance ahead, though it is not clear yet if the faster earnings growth can be sustained. Coincident or not, May was the first month this year that international developed large-cap stocks outperformed U.S. large-caps.
The graph above shows international developed market earnings that have lagged the U.S. rebound since the pandemic started but have performed better in the most recent quarter.
5. Peak growth & fast-rising expectations pose headwinds
• While the pace of blistering earnings growth is expected to continue as S&P 500 earnings are projected to grow double-digits for the remaining three quarters of 2021, we believe the second-quarter growth will likely mark the peak. We think that the expected deceleration in growth will simply reflect the return to a more normal, steady-state for the economy, rather than the end of the cycle. Still, a potential slowdown combined with elevated expectations could translate into muted short-term returns.
• In terms of expectations, analysts have revised 2021 earnings estimates higher at the fastest pace in the past 25 years, with 2022 EPS also rising at a fast clip. No doubt this reflects an improving economy, but it is likely that the bulk of the upward revisions are behind us. Also, we would note that next year's estimates are not accounting for any potential corporate tax hikes, which would trim earnings anywhere between 4%-9% based on our estimates on what has been proposed so far.
The graph above shows S&P 500 earnings which are projected to grow double-digits for the remaining three quarters of 2021 before slowing to a more normal pace.
The bottom line
• The earnings story continues to be a positive one, with economic strength and improvements in profitability both driving numbers higher. This strong cyclical rebound in earnings will provide additional fuel for the bull market to extend its longevity, in our view.
• The pace of market gains is likely to slow, especially if valuations normalize some as we expect, but improving corporate fundamentals provide enough cushion, in our view, to sustain the upward trajectory in stocks.
• Within the context of a well-diversified portfolio, we recommend investors slightly overweight economically sensitive investments and select international asset classes (emerging-market stocks and international small-/mid-cap stocks) that, in our view, have the potential to enhance portfolio returns.