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

After a significant 28 percent rally since late Oct. 2020, the S&P 500 has been treading water of late despite an ultra-strong earnings season and a surge in earnings estimates for this year and next. The potential implications of higher inflation, supply-chain constraints, and economic overheating, along with jitters about Federal Reserve policy, have contributed to the market’s pause and prompted sector rotation. Growth stocks have lagged, particularly those that are technology-oriented. Value sectors have held up better, especially the most economically sensitive areas, otherwise known as cyclicals.

Even though the market is largely yawning at the strong earnings season, we think investors should not overlook the bigger trends that are afoot.

Will GDP boost earnings growth?

Strong pent-up demand due to the economic reopening is driving robust Q1 results. Also contributing are prudent cost-savings measures by many companies and improved pricing power, which have led to favorable operating leverage and profit margin expansion.

Earnings estimates have risen a lot, especially lately
The change in the S&P 500 annual earnings-per-share consensus estimates since September 2020

The line chart shows how the consensus forecast for S&P 500 annual earnings per share has increased since the beginning of September 2020. For the 2021 forecast, it has risen from $166 per share to $187 currently, with much of the increase occurring in just the past few months. For the 2022 forecast, it has risen from $190 to $210 currently in a similar pattern, although the recent increases have been less pronounced.

2022 consensus estimate

2021 consensus estimate

Source - RBC Wealth Management, Refinitiv I/B/E/S; weekly data except for the most recent on 5/5/21

With 84 percent of S&P 500 companies having reported Q1 results thus far, 87 percent have exceeded the consensus earnings forecast, according to Refinitiv I/B/E/S. Notably, the magnitude of earnings beats has been high at 23 percent, on average, compared to the 6.9 percent five-year average. The Q1 consensus earnings growth rate has jumped to 50 percent y/y from 24 percent at the start of the reporting season. Revenue growth is also strong, pacing at 12.6 percent y/y. The outsized earnings and revenue surprises have been broad, crossing a diverse group of sectors, rather than concentrated in two or three sectors as is usually the case.

Is additional earnings optimism warranted? We think so—especially for this year. While it’s common for industry analysts and equity strategists to ultimately get too bullish with their earnings forecasts, we don’t think that’s the case yet.

This year, U.S. earnings should eclipse the previous record high
S&P 500 annual EPS: Historical (dark blue) and consensus estimates (light blue)

The bar chart shows the progression of S&P 500 annual earnings per share. Actual reported earnings were as follows: $132 in 2017, $162 in 2018, $163 in 2019, and $133 in 2020. The consensus estimate for 2021 and 2022 earnings is $187 and $210, respectively. So the 2021 forecast is that earnings will eclipse the previous peak.

Source - RBC Wealth Management, Refinitiv I/B/E/S; estimates as of 5/5/21

U.S. GDP is expected to climb at its fastest pace in nearly four decades. The consensus forecast is for 6.25 percent growth in 2021, but GDP could eclipse that level if strong household demand persists. An economic boom surpassing that of the early 1980s is not out of the question, according to RBC Capital Markets, LLC Chief U.S. Economist Tom Porcelli.

Incremental GDP growth matters. Our national research correspondent estimates that every one percent positive change in nominal GDP growth (i.e., real GDP plus inflation) results in an increase of 2.5 to three percent in S&P 500 revenues. While the magnitude of revenue gains differs in other studies, there is little doubt in our minds that incremental nominal GDP growth boosts revenue growth—the two tend to go hand in hand.

Management teams and Wall Street analysts have not yet calibrated their 2021 earnings forecasts for outsized—or even 6.25 percent—GDP growth, in our view. The economy’s dramatic on/off switching due to the COVID-19 shutdowns last year and reopening this year, combined with unprecedented fiscal and monetary stimulus, make earnings forecasting very challenging. We think both management teams and analysts have leaned toward conservative estimating or are hesitant to provide forecasts altogether. A much lower proportion of companies have given Q2 or full-year guidance than in the pre-pandemic period.

We think 2021 earnings will beat the consensus forecast; 2022 is a tougher call
S&P 500 annual EPS forecasts

The bar chart shows the differences in S&P 500 annual earnings-per-share estimates. For 2021, RBC Capital Markets is forecasting $187 per share, while the consensus is forecasting $187 and our national research correspondent is forecasting $200. For 2022, the same sources are forecasting $200, $210, and $215 per share, respectively.

RBC Capital Markets


National research correspondent

* Incorporates potential corporate tax rate hikes. 2022 earnings estimates of both RBC Capital Markets and our national research correspondent assume the statutory rate will rise to 25% from 21%. Other macro and fundamental factors account for the difference in forecasts between the two sources.

Source - RBC Wealth Management, RBC Capital Markets, Refinitiv I/B/E/S (consensus forecasts), National research correspondent; all estimates as of 5/5/21

The uniquely buoyant inflation and commodity price environments also point to margin expansion opportunities, in our view. Inflation expectations and stock prices tend to be positively correlated; when the former rises, the later also tends to move up. Furthermore, when commodity prices rise, many industries typically have pricing power—even non-commodity producers.

Good news travels fast

We believe the market has already absorbed a lot of this good earnings news. Stocks’ response to strong Q1 trends has been tame, below the excitement of recent quarters, but similar to the long-term average. We think the S&P 500 year-over-year earnings growth rate is likely to peak in the Q2 reporting season due to the very easy comparison to results during the COVID-19 lockdown, although we see upside to the Q2 consensus forecast of 61 percent y/y. Furthermore, RBC Capital Markets points out that the peak in the pace of upward earnings revisions—a metric that institutional investors take note of—may already be in the rear view mirror. We think revisions could slow meaningfully after Q2 earnings beats are factored in.

A potential slowdown in earnings revisions and growth momentum could nudge the market into a longer consolidation period or a pullback—this would be normal. However, we think any market wobbles would prove transitory. While the S&P 500 is likely to soon reach its maximum earnings growth rate for this cycle, the overall level of corporate earnings doesn’t seem set to peak any time soon. It’s still early in the business cycle, and the tight credit conditions necessary to produce corporate earnings declines, the next recession, and an equity bear market look to be a long way off. We would continue to moderately Overweight equities in portfolios, and tilt U.S. exposure toward value-oriented cyclicals.

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Kelly Bogdanova

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