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The economy is booming—but is this as good as it gets?

Earnings season is off to a strong start, but these three changes could surprise markets.


Earnings season is off to a strong start, but these three changes could surprise markets.

Our Top Market Takeaways for April 16, 2021.

Markets in a minute

The boom is here. This week, retail sales came in at almost 10% month-over-month (the second-highest surge on record), and are now 17% higher than they were in January 2020. The Philadelphia Fed’s Business Outlook Survey reached levels not seen since 1973. Initial jobless claims came in at the lowest levels since the pandemic began. Shipping rates and lumber prices are skyrocketing, and the highest proportion of businesses on record are reporting that inventories are too low. 

The Atlanta Fed’s real-time forecast for first-quarter GDP growth is 8.3% (seasonally adjusted at an annual rate). Meanwhile, the limited amount of corporate earnings reports from the first quarter are signaling strength. Out of the 36 S&P 500 companies that have reported earnings, 27 have exceeded analyst estimates. Global equities climbed to an all-time high on Thursday. 

But is this as good as it gets? We don’t think so. New COVID-19 cases are at peak levels in Michigan. Most of Europe is still under a form of “lockdown.” OpenTable reservations in New York are still 40% below where they were before the pandemic. The labor market is making progress, but we likely have a few months of one million worker job gains ahead to close the gap with the pre-pandemic trend. The supply and inventory issues have to get worked out eventually, and it seems like the solution is to hire more workers and increase capacity through investment.

The time will come when the best of the economic and earnings momentum is behind us, but we still think there are a few more months of acceleration ahead. But in investing, there are always some curveballs. What could they be this quarter?

Thought experiment: Potential second-quarter narratives

A few weeks ago, we updated our 2021 Outlook. In short, we believe the global healing process will continue. But beyond our outlook, changes are inevitable.

Take Q1. There was a “Taper Tantrum II” in sovereign bond markets, the GameStop saga went viral, and something called an NFT took over the art market.

So what narratives might pop up in the second quarter? Here are some candidates.

1. The European catch-up

The setup: Europe has been lagging in economic reopening, given lackluster fiscal stimulus, uninspiring (at best) or disastrous (at worst) vaccine progress, and a continuation of COVID restrictions. The euro is weaker against seven of 10 G10 currencies year-to-date, and the Euro Stoxx 600 is up only +9% from pre-COVID levels versus the United States up ~+30%.

The catalyst: European reopening. Pfizer is set to deliver 250 million doses in Q2 to relieve the challenged Astra Zeneca jab, and daily administrations are finally accelerating in Germany, France and Spain. Improving vaccine and virus trends could enable relaxed restrictions and increased mobility. Pent-up consumer demand could finally contribute to economic and earnings momentum. Manufacturing is already surging (German factory orders are 6% above pre-COVID levels), but sectors tied to mobility have lagged their U.S. counterparts (Ryanair is flat year-to-date while Southwest Airlines has rallied 35%).

The trade: Long euro and European equities. If we are at a point of “peak pessimism” on the European Central Bank’s rate hike outlook (the market is actually pricing the possibility of cuts) and “peak optimism” for the Fed, then closing the monetary policy divergence between the two would lead to a stronger euro. For equity markets, the catch-up could be driven by rising earnings expectations (which are still down over -10% from pre-COVID levels) and valuation expansion (European shares are trading at a wider than normal discount to the United States). Just getting back to flat earnings per share (EPS) and applying the 10-year average discount could mean a greater than 20% price return for the Eurostoxx 600, and shares levered to pent-up consumer demand and mobility would likely lead.

2. The overheating economy

The setup: $6.8 trillion (35% of GDP) in deficit spending in 2020 and 2021; $4.6 trillion (25% of GDP) in quantitative easing. This historic fiscal and monetary thrust is being delivered on top of a rapidly accelerating economy. There is “no end in sight” to the supply chain bottlenecks, and rising prices for input goods are already pinching manufacturers. Many employers are already reporting having trouble finding appropriately skilled workers. All of which could lead to quickly spiraling inflation.

The catalyst: Hot Consumer Price Index (CPI) prints. Strong demand for goods, reinvigorated demand for services, and base effects from last year’s “lockdown” levels could cause core CPI to print above 2.5% for the first time since 2007 (14 years ago). Strong inflation prints could lead some to believe the inflation spike is not so “transitory” after all.  

The trade: Long banks and real assets. Banks have just recently broken out of their 2007 peak, and their valuations would likely expand if inflation expectations continue to climb higher. Real assets such as real estate, infrastructure and industrial commodities would likely provide decent protection in an inflationary environment. In this environment, investors would probably want to avoid Treasury bonds and anything else with long duration (such as low-profitability secular growth stocks). 

3. The earnings surge

The setup: Analysts expect S&P 500 EPS of $176 in 2021, which is 8% higher than pre-COVID levels and 25% higher than 2020 earnings. There is a chance that EPS expectations are too low. For context, in 2010 EPS grew 40% from 2009 and matched 2007 levels.

The catalyst: Earnings season. If companies can beat earnings expectations at a 15%–20% pace (as they did in Q4 2020), it would imply full-year earnings of ~$200 in 2021. Coincidentally, a 40% growth rate to match 2010’s EPS growth rate would also get the index to $200 in EPS in 2021. Analysts don’t expect the S&P 500 to earn that much until 2022.

The trade: Long stocks. Here is the mental math. Let’s say S&P 500 EPS over the next 12 months should be $200. Even if you keep the price-to-earnings multiple flat, that implies a level of 4,400 on the S&P 500. If you can talk yourself into some multiple expansion (because of clarity on the COVID or policy front, or because the interest rate market calms down), you could even get to something like a 23x multiple.

23 x 200 = 4,600 on the S&P 500.

Cats and dogs living in harmony. Mass hysteria. The Stay-Puft Marshmallow Man shows up. We all go home happy.

While we know something will change in the second quarter, we feel our current positioning is appropriate for a market environment characterized by the transition from recovery and “hope” to expansion and “growth.” Beyond that, our three key investment themes of finding yield, harnessing growth and megatrends, and diversifying through the recovery should help investors navigate this ever-changing market environment.  

 

 

 

 

All market and economic data as of April 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice

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