With all the talk about inflation expectations, central bank policy, rising Treasury yields and fiscal policies, it’s no wonder equity investors are trying to make sense of the market by focusing on the interest-rate sensitivity of valuations and the tug of war between (long-duration) growth stocks and (short-duration) value stocks.
But earnings growth, rather than changes in valuation multiples, remains much the most important determinant of equity market returns beyond a very short time horizon. From at least the 1960s onwards, if we look beyond a three-year holding period, earnings growth has been 80 – 90% correlated with stock market returns.
The second quarter earnings season kicks off this week. Since it is likely to be a record-setter for growth, it is critical that investors not lose sight of these significant fundamental developments.
A High-Growth Environment
We are currently in a high-growth environment. The World Bank expects global GDP growth to hit 5.6% this year. The Conference Board has the U.S. expanding by 6.6%—and an astonishing 9.0% annualized over the second quarter.
This strong growth will likely be reflected in corporate earnings.
First-quarter earnings for S&P 500 companies were up almost 50% on the same period last year. But it is the three months just completed that analysts expect to mark the peak in year-on-year growth. The latest consensus estimate reported by Refinitiv I/B/E/S puts second-quarter year-on-year earnings growth at 65.1%. Certainly, the period one year ago was unusually weak, but we haven’t seen anything like that rate of growth since the recovery from the financial crisis back in 2009.
At Neuberger Berman, we believe S&P 500 companies will book $205 of earnings per share this year, 47% higher than last year. We think the financial and energy sectors are likely to lead, as two of the most economically sensitive sectors. Service-oriented consumer discretionary industries that are yet to recover fully from lockdown disruption, such as hospitality, entertainment, restaurants and airlines, should likely also show strong results.
Not Only a U.S. Story
This is largely about the low base set at the height of the pandemic crisis last year—but not entirely. A 65% jump in second quarter earnings would also be a 10% improvement on the second quarter of 2019.
It’s also not entirely a U.S. story. According to Refinitiv I/B/E/S, STOXX Europe 600 companies grew their first quarter earnings by 96%, year-on-year, and the estimate for second-quarter growth is 104%, powered by the region’s abundant pro-cyclical exporters. It’s unusual for Europe’s large companies to grow earnings faster than those of the U.S., but we may see it this year. MSCI Emerging Market Index companies may outperform the U.S., too: their 2021 earnings are estimated to grow by 50% versus last year’s.
Potential for Upside
We all appreciate that the equity markets discount future good (or bad) news, so what could all of this mean for the return outlook for the next six to 12 months?
This is where we do need to come back to valuations. At near-dotcom era multiples, neither U.S. nor European stocks are cheap relative to historical metrics. We think second-quarter earnings estimates have already been discounted in the market.
Nonetheless, when the swings are this wide, estimates can be wide of the mark, too. Over recent months, analysts have generally been scrambling to upgrade their forecasts to keep up with the pace of recovery, and a lot of companies think they are still behind the curve: of the 103 S&P 500 firms offering second-quarter earnings guidance, a record 66 said they would do better than the median analyst’s estimate, according to FactSet figures released on June 25.
Markets don’t typically go up or down in a straight line. There tends to be volatility in the natural course of a bull market cycle, especially with central banks adjusting their policy stance as the recovery sets in. But we believe investors would be better served by focusing on earnings rather than getting too caught up in whether the 10-year yield is 1.50% or 2.00%—particularly when those earnings are growing at such a robust rate.
Should the momentum in earnings continue—and we think it will—we believe the market can remain resilient as policymakers adjust their thinking. We believe that leaves potential upside in equity markets as earnings are reported, not just this quarter, but over the next few as well.
In Case You Missed It
- S&P Case-Shiller Home Prices Index: April home prices increased 2.1% month-over-month and increased 14.9% year-over-year (NSA); +1.6% month-over-month (SA)
- U.S. Consumer Confidence: +7.3 to 127.3 in June
- Eurozone Consumer Price Index: +1.9% in June year-over-year
- ISM Manufacturing Index: -0.6 to 60.6 in June
- U.S. Initial Jobless Claims: +364,000 for the week ending June 26
- U.S. Employment Rate: Nonfarm payrolls increased by 850,000 and the unemployment rate increased to 5.9% in June
What to Watch For
- Tuesday, July 6:
- ISM Non-Manufacturing Index
- Wednesday July 7:
- FOMC Minutes
- Thursday July 8:
- U.S. Initial Jobless Claims