First-quarter earnings season is well underway and is poised to beat lofty expectations. In many respects, this is unsurprising given the progress of vaccine rollouts and latest string of strong economic data.
With an improvement in earnings largely priced in, it is important to consider the possible risks that could impact earnings in the future. Let’s take a look at the results to date, potential headwinds and what this earnings season may reveal about equities moving forward.
A High Bar
It has been quite a journey from the COVID-19-induced earnings recession that came upon us last year. As illustrated in the exhibit below, the S&P 500 was able to deliver positive year-over-year results starting in the fourth quarter of last year. The actual year-over-year 4% earnings growth surprised to the upside as companies benefited from pent-up demand, an easing of restrictions and the promise of vaccines. This current earnings season’s bar is set high, but is based on expectations that consumers will begin to resume their normal activities, economies will continue to reopen and companies will face easy comparisons compared to the first quarter of 2020.
Exhibit 1: Earnings Rebound
At the start of earnings season (March 31), expectations for year-over-year earnings growth were forecast at a very strong 23.8%, according to FactSet. Revenues were forecast at 6.3% year over year.
As of April 30, the blended earnings growth rate for the first quarter is 45.8% (this rate combines actual results for companies that have reported and estimated results for companies that have yet to report). If that is the actual growth rate achieved, it will be the fastest quarterly year-over-year earnings growth since the first quarter of 2010 (55.4%). Of those companies that have already reported (roughly 60% of the companies in the S&P 500), over 86% posted earnings surprises and 78% had positive surprises on revenue. All eleven sectors have higher earnings growth rates or smaller earnings declines today compared to March 31 due to upward revisions to EPS estimates and positive EPS surprises, led by the consumer discretionary, financials and communication services sectors. Normally, about two-thirds of companies beat expectations—by an average of about 4.5%. In terms of revenue, 78% of S&P 500 companies have reported actual revenues above estimates. The blended revenue growth now stands at 9.1% compared to the 6.2% estimated at the end of first quarter.
This is also the first quarter since the pandemic began where CEOs of companies have had a clear enough vision of what lies ahead to issue guidance, which has thus far been largely positive. This fact alone may be one of the reasons why markets seem to be taking this earnings season in stride, even with the high expectations going into it.
Not all stocks have fared so well during this earnings season. As a result of high expectations, and the possible belief that their best days may be behind them, the market has been critical of those companies that have missed expectations, especially in the work-from-home, stay-at-home stocks that were such strong performers off the market low of 2020.
Possible Headwinds to Earnings
While an improving economy is good for earnings, it can prompt some negative side effects. An economy that improves too quickly could lead to rising interest rates brought on by the threat or the manifestation of higher inflation. Higher rates and inflation can weigh on earnings, primarily through margin pressure, as costs rise more than a company’s ability to raise prices.
Treasury yields have been rising since the start of the year, with the 10-year moving from 0.96% at the start of the year to a high of 1.75% in March before settling around 1.60% more recently. But, as we saw, the sharp move higher in rates witnessed in March created some challenges for equity markets as investors reconsidered not only the multiples they were willing to pay for stocks but also the negative impact on company earnings.
And while overall markets continue to make new highs, stock leadership has changed significantly since rates moved higher. More cyclically oriented, value stocks began to build on the relative outperformance over growth stocks — a trend that began late last year. While the 10-year Treasury note has settled nicely into a trading range, its recent high perhaps begins to recognize that the Federal Reserve will remain on hold while balancing inflation expectations.
The latest consumer and wholesale inflation numbers came in hotter than expected with the Consumer Price Index up 2.6% and the Producer Price Index up 4.2% in March from a year ago. In addition, constrained supply in certain areas of the market, such as semiconductor chips needed for automobiles, could add to inflationary pressures near term. Inflation isn’t necessarily bad for earnings as companies can pass some of their increased costs onto consumers. However, we expect these stronger-than-expected inflation numbers will be transitory in nature given the very low readings during the pandemic as well as structural forces such as demographics and technology improvements, which should keep longer-term inflation at bay.
Lastly, any increase in corporate taxes could weigh on earnings. However, with negotiations still underway on the Biden administration’s multitrillion-dollar economic plan, any change in the corporate tax rate is unlikely to impact earnings until next year. Thus, we continue to expect S&P 500 operating earnings to come in around $170-$175 for 2021. And that number may prove to be too conservative as the reopening trade continues to take hold.
Positive on Equities with a Small Overweight
Overall, the rebound in earnings from the COVID-19-induced recession has been impressive. While this quarter’s bar is set high, it appears most companies are poised to beat expectations. Guidance we’ve heard from companies points to a much brighter future, with plans for investment and hiring in many parts of the economy. These robust earnings results and insights align with our view of a stronger economic recovery in the second half of the year that should allow stocks to grow into somewhat elevated valuations.
While strong earnings growth is needed for the continuation of what we believe is a new bull market, the number of stocks participating in the rally is important as well. Unlike what we saw last year, when the market was led by a few technology companies, we are seeing a broadening of market breadth. For example, 95% of companies in the S&P 500 are trading above their 200-day moving average. This suggests a market that has further to run, even as it hovers near all-time highs.
With this backdrop of accelerating earnings and economic growth, progress toward herd immunity and strong policy support coming from the Federal Reserve, we recommend a small overweight to equities within a diversified portfolio. However, we remind investors to reset expectations for the remainder of the year, as the second year after a market low has historically meant more market volatility and more measured returns.