The View From Above

Top Takeaways

• Q2 S&P 500 earnings are expected to increase by 63.6% YoY
• Estimates have risen by a record amount since start of the quarter
• Positive pre-announcements outpacing historical levels
• 2021 Earnings ~18% higher than 2019 levels
• Capital Return Programs accelerating

What will investors be listening for on Conference Calls?

• How did business trend throughout the quarter? Did this differ across geographies?
• Are margins being pressured by cost inflation associated with raw materials, logistics or wages?
  • How are you mitigating these?
  • How long do you think these cost pressures will persist?
  • Are you raising prices?
• How are you navigating the volatile commodity/rate environment?
• How much leverage is there in the business model to these changing prices?
• How are you managing supply chain disruptions and inventory levels?
• What does the capital return program look like on an ongoing basis?
• Are you planning on increasing Cap-ex spending?
• Has demand shifted as a result of stimulus? Do you expect to see a drop-off as those benefits end?
• What are your expectations for additional stimulus or tax changes? How is this affecting business decisions?
• How have strategic initiatives (digital transformation etc.) over the last year positioned the company going forward?
• How is the company thinking about the post-pandemic workplace/workforce?
• How are ESG issues impacting strategy?

Setting the Stage - A look back at Q2
 
The rally rages on. For the fifth consecutive quarter the S&P 500 gained over 5% ending Q2 up 8.2% and 14.4% for the year. The quarter could distinctly be broken into two halves with the key inflection point occurring on May 12^th when the April CPI data was released showing a 4.2% y/y increase in prices. This ultimately turned out to be the height of inflation fears. At the start of the quarter the reflation trade was firmly in control as we saw the economic recovery accelerating. Commodity prices were surging (copper and wheat up ~23%, lumber up an astounding 65%) which fed the runaway inflation fears, despite the Federal Reserve maintaining its view that this would ultimately prove to be transitory. In typical “sell the news” fashion commodities topped out right as the first the scary piece of inflation data hit the tape. Right around the same time China began to crackdown on commodity markets which also helped stem the speculative fervor. In the back half of the quarter copper and wheat both pulled back ~12% from the highs while lumber plunged ~55%, ending the quarter down 27%.
 
At the start of Q2 the 10yr yield was ~1.75%, after nearly doubling in Q1.  Rates then drifted lower throughout quarter as inflation fears eased. The move lower in rates was one of the key drivers within equity markets. The crowded reflation trade started to unwind and tech/growth rallied in the back half of the quarter. This accelerated as the Federal Reserve signaled it could start to rein in easy money policy sooner than previously expected. As the quarter ends the market is trapped in the “peak everything” narrative with some Covid-variant concerns in the back of investor’s minds. Fiscal and monetary policy support have already started the slow decent from the apex. Meanwhile the economic growth rate is still running above trend but is starting to normalize. Which brings us to corporate earnings. Last year, Q2 marked the depths of the crisis and as such the y/y comps will be the most favorable. Let’s go…… 

Inside the Numbers

• Q1 S&P 500 earnings grew ~52% YoY as 86% of companies beat analyst estimates by over 20%
• Q2 earnings are projected to increase 63.6% YoY with revenues projected to grow 19.6%
  • Earnings expected to show largest YoY growth rate since Q4 2009 (~109%)
• Record number of positive pre-announcements (exceeding last quarter’s record)
  • 64% of companies issuing positive guidance vs. 5yr average of 35%
• Pre-announcements and positive analyst revisions have pushed estimates higher by a record 7.3% since the start of the quarter
  • Over the last 15 years estimates have declined by an average of 5% during the quarter
  • This is the fourth consecutive quarter we have seen this dynamic - first time since 2004
  • Energy and Materials have seen the largest revision due to rising commodity prices
• Corporations have restored capital return programs
  • According to S&P Global S&P 500 Q1 buybacks were up ~36.5% QoQ but remained 10% below 2020 levels
    • in Q1 335 companies repurchased >$5ml up from 244 in the previous quarter
  • S&P senior index analyst, Howard Silverblatt, expects 2021 buybacks will exceed 2020 levels
  • The Federal Reserve recently lifted capital return restrictions on banks which will drive further growth in the second half

 
The Big Picture
2021 earnings are expected to rebound ~38% from last year’s levels but more impressively this is ~19% above 2019 earnings. In the previous three quarters, despite positive earnings revisions companies still managed to top those estimates by a wide margin. This was due in part to how sharply estimates had been slashed last year and the lack of visibility. Clearly, a stronger than expected economic recovery was a tailwind. However, we should not overlook strategic decisions made by management teams to cut costs and shift business models early in the crisis which provided additional operating leverage. On a y/y basis this is the quarter that those benefits will be most visible.
 
The current environment provides a new set of challenges. While there is more visibility on the demand side of the equation companies are struggling to ramp up production and hire back workers. Cost pressures are increasing from all directions including raw materials, wages and transportation. Which leads to the biggest question as we head into earnings season: how are companies meeting these challenges and will margins begin to compress going forward?
 
We expect another strong earnings season from a statistical perspective. However, as we saw last quarter even when companies blew away estimates the stock reactions were muted. The S&P 500 has rallied ~85% off the March 2020 lows and ~33% from the pre-crisis highs. This staggering rally has brought with it valuation concerns. One key factor I want to highlight: the rally in the back-half of last year was driven by multiple expansion as the P/E went from ~19X at the end of Q2 to ~23X at year-end based off of 2021 earnings estimates. The gains this year have only kept pace with earnings revisions with the P/E holding steady with the S&P 500 trading around 23X 2021 estimates. As we have crossed over the half-way point of the year the street is already starting to focus on 2022 numbers. Street estimates are calling for ~13% earnings growth next year, which if recent history is a guide may prove to be conservative. At current levels the S&P 500 is trading at ~20X 2022 earnings, which is not wildly rich in an above-trend growth environment assuming those inflation fears don’t come to roost.     
 
Data compliments of FactSet Earnings Insight as of July 2,

• If actual Q2 earnings grow by 63.6% YoY it will be largest increase since Q4 2019 (+108.9%)
  • All 11 sectors are expected to report earnings growth
    • 4 sectors expected to grow by >100%: Industrials (+348%), Consumer Discretionary (+205.2%), Financials (+117%), Materials (+116.1%)
      • Energy goes from $10.6B loss to $13.8B profit
    • Smallest increases: Utilities (+0.6%) and Consumer Staples (+8.3)
• Q2 YoY Revenue is expected to grow 19.6% YoY - the highest since tracking began in 2008
• All sectors are expected to report revenue increases
  • 3 sectors with revenue growth >30%: Energy (+86.5%), Consumer Discretionary (+32.1%), Materials (+32%)
  • 3 sectors with revenue growth <10%: Consumer Staples (+5.6%), Utilities (+5.5%), Financials (+4.4%)
• 2021 EPS estimates: +35.5%, Revenues +12.4%
• 2022 EPS estimates: +13%, Revenues +6.5%
• YoY Earnings growth begins to trend lower over next two quarters but still >15%
• Valuation: Forward 12-month P/E ratio is 21.4, above the 5yr avg. of 18.1 and above the 10yr avg. of 16.1

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