Corporate profitability, Covid-19 developments, fiscal policy and US Elections: The four drivers of equity market direction (and rotation)
US earnings season kicks off today (JPMorgan Chase, Citigroup and Johnson & Johnson). For the third quarter of 2020, S&P500 companies are expected to report a decline in earnings amounting to -21% yoy according to consensus. Note that the Q2:2020 reporting season saw earnings beating forecasts at a strong pace of 12 pps (mean value) versus 6 pps on average albeit from a very pessimistic base with S&P500 EPS actual growth of -32% yoy from -44% yoy expected at the beginning of the Q2 season. For the Full Year (FY) 2020, consensus analysts’ expect an earnings decline of -18% ($131 per share) due to the pandemic-related contraction in economic activity in the second quarter of the year. Recall that US real GDP declined by -9% yoy in Q2:2020 with global real GDP growth contracting also.
Looking forward, corporate profitability is expected to recover due to a strong macro rebound with double-digit positive figures expected as early as the Q1:2021 (FY2021: 25% or $165 per share). Analysts have become more optimistic in the past months as the prospect regarding generalized lockdowns remains lower than in the first covid-19 wave, for now (see graph page 1). The earnings bounce back appears impressive when it is described in terms of the time it will take reach 2019 earnings levels ($161 per share), albeit taking into account the fact the correct reference point is the earnings trend which was projected before the pandemic (FY2021 EPS of $195 as of January 2020).
All told, the profitability outlook is more uncertain than usual with the economic outlook mostly dependent on how the coronavirus pandemic correlates with the drop in mobility thus jeopardizing the sustained recovery of the services sector. Moreover, the size and the mix (taxes vs. spending) in the 2021 US fiscal policy remains conditional on the November elections’ outcome. The odds for a “Blue Wave” sweeping away the Republican majority in the Senate, with former VP Biden winning the presidency have increased in the past ten days, also taking into account the probability of a contested US election result having now lessened. As a result, equity markets rose significantly in the past week with the S&P500 gaining 3.8% with all 11 sectors ending in positive territory. At the same time, speculative corporate bond spreads narrowed by 46 bps ending the week below 500 bps materially for the first time since March.
Our view here is that in the short term, such a scenario (Blue Wave) would be positive for risk appetite as the likelihood of a significant fiscal drag in 2021 is diminishing. In the medium-term, the Biden tax plan focuses on increasing taxes on corporates (statutory rate: 28% from 21%), capital income and the ordinary income for high-income filers with the aim of raising $3.4 trillion in new revenues in order to fund the $5.4 trillion in spending over the fiscal years 2021-2030 according to the Penn/Wharton Budget Model.
We view the agenda as a mixed bag with regards to their likely impact on stock prices, with the large infrastructure and R&D expansion proposed by the Biden agenda ($1.6 trillion) likely to support a tilt toward more cyclical parts of the equity market with Industrials and Materials benefiting the most. Technology stocks would come under scrutiny regarding monopolistic behavior suggesting that the marked outperformance of the growth stocks versus value stocks (41% since 2020) may be scaled down. Positive vaccine news could also support this rotation (see graph page 1).