‘Tis the Season – Commentary

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Below is commentary by John Lynch, Chief Investment Officer for Comerica Wealth Management. Companies are reporting Q4 earnings. Investors are focused on inflation, rates and margins. We continue to look for leadership from value and cyclical sectors.

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'Tis The Earnings Season

If a company reported fourth quarter earnings in a forest and no one was around, would it make a sound?  If that same company warned of rising input costs in 2022, or expressed confidence in pricing power going forward, there would be a lot of noise!

Such is the challenge for companies reporting in earnings season this month.  No one really cares about fourth quarter earnings - it’s all about company visibility on the year ahead.

  • The S&P 500 Index eclipsed record levels on 70 different occasions in 2021, supported by low interest rates and high earnings growth.  Operating earnings for companies in the S&P 500 Index are projected to climb in excess of 45.0% over the past year and we believe that success has already been priced into stocks.
  • Moreover, FactSet reports the pace of earnings per share (EPS) growth has moderated significantly from ~90.0% in the second quarter, to ~40.0% in the third quarter, to ~22.0% in the fourth quarter.
  • We look for Index EPS to exceed consensus expectations with growth of up to 25.0% for the period ending in December.  This is a pace greater than three times the historical average and may still not be enough to satisfy investors.

Instead, we believe the focus will entirely be on corporate visibility – what do CEO’s and CFO’s say about inflation, input costs, and margins – for 2022.  Added color on companies’ perception of Omicron as a threat to economic activity, as well as their thoughts on Build Back Better, may also factor into whether or not investors reward, or punish, their stocks during earnings reporting season.

We continue to look for cyclicality to lead the profit parade for the fourth quarter, 2021 and in 2022.  Our favorite sectors include Energy, Industrials, Materials and Financial Services as we look for the combination of growth in profits and income to generate total return for investors this year.

4Q21 EPS Preview

Companies in the S&P 500 are projected to report operating earnings growth of 21.7% year over year (YOY) for the fourth quarter, according to the FactSet consensus estimate.  This would represent the fourth consecutive period over the past year in which the Index has exceeded 20.0% growth, due to the combination of stronger than expected operating leverage and easy comparisons with the pandemic-related profit trough of 2020.

Corporate revenue growth is also projected to remain strong, with sales projected to come in at 12.9% in the fourth quarter.  This would represent the third highest quarterly revenue gain since FactSet started monitoring the data in 2008, surpassed only by the prior two quarters.  In a sign of the depth of the economic recovery, all eleven sectors of the S&P 500 are expected to experience revenue gains, led by the Energy and Materials sectors.

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Throughout the profit recovery from the lockdown lows in the spring of 2020, corporate operating leverage has dramatically exceeded expectations.  Businesses have kept income statements tight, managing labor, input, and interest costs effectively.  As a result, strong sales gains have dropped to the bottom line more quickly than usual.  We look for the fourth quarter to prove no different from recent trends, with net profit margins hovering in the 12.0% range for the Index.

Sector Contribution

Leadership in the fourth quarter profit parade is expected to come from the Energy, Materials, and Industrials sectors.

  • Energy – After total industry losses of approximately $100 million in the fourth quarter of 2020, the sector is projected to earn in excess of $28 billion for the period ending in December.  Given the loss last year, FactSet does not calculate YOY growth change.  Yet it is instructive to see the impact of higher oil prices on energy’s profit recovery.  In 4Q21, the average price of oil was $77.00 compared to $42.00 average for oil one year ago, an increase of 80.0%!
  • Industrials – The sector is projected to deliver EPS growth of 108.0% YOY, with the Aerospace & Defense and Airlines industries leading the way.  The global economic recovery helped drive the group, despite a stronger than expected U.S. dollar.
  • Materials – Profits are expected to climb 60.0% YOY in 4Q21, as the Metals & Mining and Chemicals industries generate the highest EPS growth.  Surging commodity prices and renewed demand were primary drivers of the sector’s profit gains.

Other cyclical sectors, including Financial Services and Consumer Discretionary, face daunting comparisons from the previous year’s profitability.

When the final tally is completed in the coming weeks, the broad strength in corporate profits should see S&P 500 earnings of $205.00, an increase of more than 45.0% for 2021.

2022 EPS Outlook

After the exceptional EPS growth rates achieved for the Index last year, investors should prepare for a more normalized profit landscape in 2022.  We project operating earnings growth in the range of 9.0% - 10.0%, to $225.00, for companies in the S&P 500 this year.  Revenues should climb in the 7.0% range, with the net profit margin for the Index holding above 12.0% in 2022.

A concern we had over the past year was that proposed corporate tax hikes for 2022 could potentially limit, or cap, S&P 500 EPS at 2021 levels.  The legislative process removed the corporate tax increase in October, enabling U.S. companies to hold $134 billion in more cash in 2022 than under the initial proposal, according to a study by Strategas Research Partners.  This extra cash can be used for investments to grow their businesses as well as to meet the wage demands of the tight labor market.  It should also be pointed out that given the rebound in the economy and equity markets last year, corporate tax revenue, at the lower rates, still grew by a record amount to $400 billion in 2021.  This compares favorably to the previous record of $376 billion in 2006, when companies had a 35.0% corporate tax rate.

We still look for cyclical leadership in economic activity, EPS growth, and market performance during 2022.  Sectors positioned to benefit most from the profit recovery include Industrials, Consumer Discretionary, and Energy.  The Financial Services sector faces difficult EPS comparisons to last year given the combination of reserve releases, trading activity, and strength in housing/mortgages.  Yet we still view the trends of higher interest rates and an improving lending environment as favorable for the group, with potential merger activity boosting regional banks.

Given our expectation for gradually higher market interest rates next year with inflation declining from peak levels, we look for a TTM PE of 22.5 times our S&P 500 profit forecast of $225.00, suggesting the Index would be fairly valued in the 5000 range by yearend. Though we suspect P/E multiple growth has topped out this cycle, the combination of earnings and income could be a powerful driver of performance for long-term portfolios.

Be well and stay safe!

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