AUGUST 16, 2021 - STELLAR CORPORATE EARNINGS BUOY EQUITY MARKETS

Summer lulls could not deter global equity markets from climbing higher. Amidst light trading volumes, the S&P 500 and Dow Jones hit new all-time highs, bolstered by moderating US inflation data, advancements in the US infrastructure legislation, and what’s shaping up to be one of – if not the – best quarters for corporate earnings. International (EAFE) equities led the way for the third straight week, while Canadian equities eked out a small gain. WTI crude oil prices were flat following last week’s tumble, with the International Energy Agency (IEA) cutting its 2021 forecast for global oil demand. The updated forecast came just a day after the White House called for OPEC+ to boost oil output.

The most significant headwind facing equity markets remains the path of the coronavirus. The CDC voted in favour of recommending a third dose to those with weakened immune systems. The vote comes at a time when the delta variant has rampaged across the US. The 7-day average of new cases surpassed 125,000 this week (the highest level since early Feb. 2021, the peak 7-day case count was ~250,000 in Jan. 2021). However, the pace of the spread appears to be decelerating, signalling that the current wave may be peaking. If the US avoids further lockdown measures, investors should expect a reversal back into cyclicals from growth. Investors should also pay close attention to upcoming data on consumer confidence, PMI services, dining, and flight traffic for a potential inflection point.

Second-quarter 2021 earnings for the S&P 500 are on track to record the best quarter for earnings growth in over a decade. Of the 91% of companies reported, 87% have beat their earnings and revenue estimates. Similar to last quarter, the magnitude of the surprises is noteworthy. Recall that valuations were of particular concern at the beginning of the year, with the S&P 500 trading at a forward P/E ratio of ~27x, a level not seen since the lead up to the 2000 Dot-com bubble. As a result, consensus estimates called for muted stock market returns this year, yet, the S&P 500 has returned a remarkable 19% YTD. Today, the S&P 500 trades at ~22x forward earnings. In other words, earnings have heavily outpaced prices by a significant margin. So what gives? Were analysts that wrong, or have corporations truly hit it out of the park? We’d argue both are true.

Last year, corporations were forced to suspend forward guidance due to the substantial uncertainty stemming from the pandemic. The lack of forward guidance led to analysts being much more conservative with their estimates, thus setting a lower bar for companies to beat. Markets also underestimated how well corporations have adapted to their new environments. Indeed, much has been written about the unprecedented fiscal and monetary policy that has boosted growth. However, not enough weight has been given to the transformational shifts (work from home, cloud services, and e-commerce) that have underpinned enhanced profitability and productivity.

Despite facing wage and cost pressures, corporations are posting the highest net profit margin on record. A combination of drivers is contributing to the record high. First, corporations are reaping the rewards from last year’s cost-cutting campaign (e.g. closing offices and replacing labour with machinery). Secondly, the inability to hire workers (US JOLTs survey showed job openings rose to a record high this month to 10.1 million; 800,000 more than expected) has been a significant factor in forcing companies to do more with less. Sure, companies have had to raise wages to lure new workers, but companies have far fewer workers on their payroll. Lastly, companies have successfully passed on their increased costs to customers, who have been quite forgiving to higher prices in light of easing lockdown measures and elevated cash levels. The combination of easy monetary policy, soaring pent-up demand boosting revenues, and the ability to pass on increased costs to customers have created a very favourable environment for corporations. The outstanding Q2 corporate earnings results raise the bar that much higher going forward. And with economic growth appearing to have peaked and central banks leaning further into hawkish territory, future stock market gains could be harder to come by.

THE WEEK AHEAD

? Canadian and US housing data

? Canadian, US and Chinese retail sales data

? US monetary policy announcement

? US, Japanese and Chinese industrial production data

? Eurozone and Japanese GDP data

? UK employment and consumer confidence data

? Japanese trade data

? Chinese fixed-asset investment

? Global inflation data

? 19 S&P 500 and 2 S&P/TSX companies report earnings

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Regards,

Alex

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