By Tim Courtney, Chief Investment Officer
Earnings are on a record pace so far in 2021,1 and many companies that produced horrible numbers in 2020 like banks2 and energy companies3 have done quite well. Small companies have also been rallying with the small-cap Russell 2000 posting its best day since August this week.4 News continues to be good with many companies meeting or exceeding already elevated expectations.
However, headwinds such as supply chain problems remain in the headlines5 and some companies are starting to forecast these disruptions could last longer than initially anticipated. Accordingly, they are beginning to tamp down expectations for future earnings growth, citing these issues as a threat to their profit margins moving forward.
Now, companies are trying to decide how to best handle these challenges. Passing price increases onto consumers would help maintain profit margins and earnings growth, but there’s always a risk of losing market share if customers then pursue less expensive alternatives. Companies providing food, energy and staples may feel more confident in raising prices. For instance, Proctor and Gamble has already raised prices on household staples for the second time this year.6
One possible tailwind to earnings going forward is household spending, which still seems pretty robust as consumers resiliently devote dollars to travel and entertainment.7 The liquidity and savings people have built up could help boost earnings into next year and, while we likely won’t see the same level of growth in 2022, we still expect growth. Companies also will likely begin spending in areas that help their productivity given labor shortages, which could sustain profit margins that are historically high.
Even if earnings continue to grow, there is a variable that can affect how investors value those earnings: inflation/interest rates. If it turns out we’ll be operating in a higher inflationary environment, investors will likely start discounting future earnings more heavily. A company’s worth is largely determined by its future earnings discounted back to today, and that value becomes lower when inflation is higher.
The question is whether inflation has now truly reset itself at a higher level. It doesn’t need to stay as high as 5.4%8 to meaningfully impact the valuation of some firms. Even a rate in the 2.5%-3.5% range could make a significant difference.
Overall, 2021 earnings so far have been about as strong as anyone could have expected, and investors should be pleased. As always, however, there are challenges. Policy makers have decided that having some inflation is better for society than having deflation, and they’re probably right. Markets just hope that they don’t create too much of a good thing.
Sources:
The Russell 2000 Value Index measures the performance of small-cap value segment of the US equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Value index is constructed to provide a comprehensive and unbiased barometer for the small-cap value segment. The index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set and that the represented companies continue to reflect value characteristics.
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
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