Although the news recently has been dominated by alarming headlines about inflation, the Delta variant, and high stock valuations, we have some positive developments to look forward to: second quarter earnings reports. This past quarter will likely deliver one of best year-over-year earnings growth rates in history—the other having occurred in the wake of the financial crisis. Analysts are expecting S&P 500 companies to report average earnings growth of 69% relative to the abysmal earnings of the second quarter of 2020 when so many businesses were shut down. It will be a testament to the resiliency of US businesses, the US consumer, and the past year of monetary and fiscal support. The rapid rebound for so many underpins the nearly 40% increase in the S&P 500 since mid-2020. And while earnings may even come in above those lofty numbers, we certainly will not be seeing guidance for growth anywhere close to those rates for this quarter, this year or next year. But everyone knows this and instead will be looking to see how companies are handling reopening challenges. Will growth outlooks from here support current valuations and leave room for further appreciation in equities? And where are the danger zones?
To understand the challenges facing companies and investors, it’s important to recognize the nature of this recovery. We are in the midst of a reversal of the twin shocks of 2020. Just as the pandemic’s onset caused two simultaneous negative economic shocks—sharply lower demand and lower supply—the reopening has caused demand to return quickly, while supply comes back online more slowly. Consumers are relatively flush with cash and have a strong desire to go out and spend on everything from travel and entertainment to new cars and furniture. Companies are rushing to serve that demand, but lack the raw materials, parts, and labor to bring all those goods and services to market. Moreover, global shipping networks were also disrupted by the pandemic, so US consumers can’t even turn to imports to satisfy their demands. This mismatch has led prices to surge higher.
Those shortages are stretching out the time that earnings growth will be running ahead of normal levels. Auto production, for example, is limited by shortages in key semiconductors needed to power the electronics, but chip companies are ramping up production now. In the meantime, new and used car prices are surging. This points to several quarters of growing sales and profits for the automakers. Once supply catches up, we can expect those price increases to peter out and even to reverse in some cases. This, by the way, is one reason why at least some of the increase in inflation is expected to be transitory. Lesson for the car buyer: wait, if at all possible.
The good news for companies is that they can sell everything they can make and earnings should be strong for many quarters to come, although the pace of growth will moderate as more and more of that excess demand is satisfied. Earnings growth for the S&P 500 is likely to approach 25% (year over year) for the third quarter and to exceed 35% for the full year. Next year, those companies are likely to deliver earnings growth over 10%. Some are worried about valuations—are stocks too expensive? We don’t think so, broadly speaking, although we can point to many stocks we see as overvalued. Earnings growth at those rates provides room both for further appreciation and for some reduction in the most common measure of valuation, the 12-month forward price-to-earnings ratio (P/E). That P/E stands at 21.4 times S&P earnings (over the next twelve months) and that matches earnings growth over that time. And as earnings growth continues to run above normal as the recovery continues, stocks can continue to rise.
But the danger zones for companies and investors lie in the hurdles companies are facing in bringing production (and services) back up to speed. Shortages are stretching out the recovery period in many sectors, including services. Hotels, restaurants, and airlines are all struggling to hire and this is limiting supply. Hotel and motel rates rose 8% in June, from May, and were up 17% from June 2020. Airfares rose 7% month over month and are up 25% from last June. Those operations would rather rent out more rooms and book more flyers, but they just can’t without more workers. We would have a stronger recovery if everyone would instantly return to work, but then we’d be back to the more normal, slow growth sooner.
So, we are stuck with a gradual recovery, one slowed by supply constraints. For long term investors, this is not a problem, and the temporary disruptions afflicting some stocks can create opportunities. For companies, shortages point to higher costs—of materials, parts and labor. This is one of the danger zones—will higher costs crimp profit margins? So far, we are seeing companies pass through cost increases into prices. Once those shortages ease, input prices fall. We are seeing this in lumber, for example, where prices have fallen by more than half from their early May peak. And profit margins may very well expand if final goods prices are slow to come back down as material prices do, as seems to be the case for new homes. But when it comes to wages, reversals are rare. Once wages move higher, they are very difficult to reduce unless companies use signing bonuses or other one-time payments to lure workers back.
This earnings season, we expect companies to provide updates on those bottlenecks and the consequences for prices and margins. We expect the labor constraints to begin to ease after Labor Day when kids are back in school and extra unemployment benefits run out. This should provide further fuel to the recovery and sustain strong earnings growth. The surge in the Delta variant, first in India, and recently in Europe and the US, remains a concern as it afflicts the unvaccinated. Both the classic reopening stocks (travel, leisure, etc.) and the 10-year Treasury started moving lower as Delta became more of a concern back in March. While some areas of the market may lag, vaccinations are rising around the world and that should be a positive more broadly. Most developed economies have now delivered at least one shot to more than half their populations, and emerging markets are running ahead of expectations in vaccinations. This suggests that global reopening and recovery will provide yet another boost to the US recovery via stronger export demand just as the pace of recovery here starts to slow in 2022 and 2023. While this earnings season’s record growth will not be repeated anytime soon, US companies appear well positioned for above-normal growth for an extended period and that looks supportive of further gains in equities.
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