Kelly Bogdanova
Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.

The U.S. equity market—and most markets, for that matter—finished the first half of the year on a positive note, adding to outsized year-to-date gains. The S&P 500 rose 2.2 percent in June, ending the month at an all-time high, and has rallied 15 percent so far in 2021.

We think major equity markets have further room to run due to the strong economic and corporate earnings momentum generated by the partial taming of the COVID-19 virus and related economic reopenings, and the already implemented supersized fiscal and monetary stimulus.

Barring a vigorous return of the pandemic, we think the U.S. economy should keep powering ahead at an above-average rate through next year, at least. The consensus forecast is for U.S. Real GDP to grow 6.6 percent in 2021, and RBC Capital Markets believes it could be even higher, reaching eight percent. U.S. recession risks are nowhere in sight, according to our six leading indicators, and other major economies appear to be in favorable positions as well.

Economists expect GDP growth to jump this year, and then ease back to a more normal level by 2023
U.S. Real GDP (annual y/y %); actual in dark blue, consensus estimates in light blue

The bar chart shows that after rising 2.2% in 2019, annual U.S. Real GDP dropped -3.5% in 2020 due to the COVID-19 crisis. The consensus forecast of economists is for it to rebound sharply by 6.6% in 2021 and then to ease back to 4.1% growth in 2022 and then to a more normal level of 2.3% growth in 2023.

Source - RBC Wealth Management, Bloomberg estimates; data as of 6/30/21

The shape of things to come

Equity markets, however, will be confronted with a shifting landscape over the remainder of the year and into 2022 as central bank policies become less dovish and economic and earnings growth rates come off the boil.

For the U.S. market, we think this could lead to a transition period—from that of a robust rally phase (the S&P 500 has surged more than 90 percent since the March 2020 COVID-19 low) to a more typical market pattern of two steps forward, one step back.

There are four interrelated issues that should set the U.S. market’s tone going forward:

Above-normal inflation: Consumer inflation reached 5.0 percent year over year in May, and we expect it to remain elevated in the near term before easing down to less lofty levels toward the end of the year. We think this path is largely accepted among market participants. The greater uncertainty is inflation’s path over the next two to three years. RBC Global Asset Management’s chief economist forecasts it will remain above average during this period, and we’re not convinced the equity market has embraced this possibility. In the meantime, the debate about inflation—and the Fed’s response to it—could jostle the equity market at times.

Less dovish Fed: The Fed has already signaled it plans to shift toward less accommodative policies soon with the start of tapering of asset purchases, and then the first rate hike of the cycle will follow, perhaps in 2023, which is the Fed’s most recent projection. Neither tapering nor the beginning of the rate hike cycle would pose a threat to the equity market’s medium-term trajectory, in our view. Even so, we think market participants will fret about Fed policy and the related movement of the 10-year Treasury yield and yield curve from time to time.

There is only one historical incidence of tapering, during the previous economic expansion. The equity market was initially knocked back by the Fed’s surprise tapering announcement and had difficulty with the Fed’s later communications on this but went on to resume its bull trend thereafter. This go-around, the Fed has already more effectively prepared financial markets for tapering. In terms of rate hikes, the S&P 500 has typically rallied at an above-average pace one year before the first rate hike and has continued at an above-average rate in the two years after the first hike when a recession was not on the horizon, according to RBC Global Asset Management data going back to the 1950s. Typically, the equity market is threatened by rate hikes only when the Fed tightens too much, too fast such that a recession becomes a meaningful risk. This scenario is not currently in view.

Peak GDP growth: Q2 2021 will likely record the high-water mark of GDP growth for this recovery cycle. The consensus forecast is projecting 10 percent growth, while RBC Capital Markets believes it could reach 13.5 percent. Bursts of strong GDP growth are common early in the expansion cycle, following a recession. While the Q2 2021 level, which will be preliminarily announced on July 29, should be outsized compared to historical recovery periods, this is primarily due to the unique nature of the plunge in Q2 2020 caused by COVID-19 shutdowns and the subsequent business reopenings. More meaningful for the market will be the path of GDP growth thereafter. We think the unprecedented levels of fiscal and monetary stimulus already in the system will help GDP growth remain above average through next year, at least. In short, we are not concerned about “peak GDP growth” so long as above-trend momentum can persist.

Peak earnings growth: Some market participants are already wringing their hands about how the upcoming Q2 earnings reporting season, which will begin in mid-July, is nearly certain to represent “peak earnings growth” for this bull market cycle, which could pose a challenge for the market. The consensus forecast is for S&P 500 earnings to grow 65 percent year over year, and once beat rates are factored in we think it could reach 75 percent year over year.

The absolute level of earnings should continue to rise
S&P 500 quarterly earnings per share; actual in dark blue, consensus estimates in light blue

The bar chart shows the S&P 500 quarterly earnings plunged during the COVID-19 crisis and reached a low of $27.98 per share in Q2 2020. Since then it has rebounded and reached $49.13 per share in Q1 2021. The consensus estimate by analysts anticipates it will drift higher later this year and next year, eventually reaching $57.03 per share in Q4 2022.

Source - RBC Wealth Management, Refinitiv I/B/E/S estimates; data as of 6/25/21

Indeed, RBC Capital Markets points out that periods of peak earnings growth have historically been followed by a loss of price momentum for the market. In the early stage of the past three bull market cycles going back to 1993, the S&P 500 declined by a range of 1.0 percent to 7.6 percent in the six months following the peak rate of earnings growth. However, the effect was temporary as the market eventually resumed its upward trajectory in all three instances. The S&P 500 climbed by a total of 26 percent to 50 percent during the 36-month period following the peak in earnings growth largely because the economic expansions persisted and the absolute level of earnings continued to march higher, albeit at a slower pace. We think a similar earnings growth pattern will play out this business cycle.

All in stride

Uncertainties or periodic data contradictions related to any of these issues could create market volatility or pullbacks, but we think all four of these transitions are manageable and will not hinder worthwhile market gains over the next six to 12 months. Any wobbles in the indexes should be temporary and superseded by another leg up for the economy, corporate profits, and equity market. We would maintain a moderately Overweight position in U.S. equities in balanced portfolios with a tilt toward value sectors.

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Kelly Bogdanova

Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.
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