Can two forces continue to buoy US equity markets?

Markets seem to have detached from both earnings and macroeconomic data.  We put this down to the dual impact of liquidity and tech, the effects of which are unlikely to dissipate in the foreseeable future.

What's happened in recent months?

The S&P500 US stock market index is up more than 40% from its mid-March low as investors apparently continue to ignore the impact of the lockdown on activity and the uncertainty surrounding the earnings outlook.

Earnings for the S&P 500 almost halved in the first quarter of 2020.  Many companies suspended earnings guidance during the recent earnings season due to uncertainty around Covid-19 and announced job cuts. Companies in sectors particularly hit by the lockdown, such as airlines, said they were not expecting demand to fully recover for two to three years.

The deterioration in earnings was expected as the lockdown measures and the consequent stop in economic activity would have inevitably dragged on companies’ revenues and therefore earnings.

With such a dim outlook for earnings, we were not expecting the quick turnaround in investor confidence and the sharp rebound in stock market returns we have seen in the past couple of months.

What was behind the recent rally?

Chart 1 shows that while earnings have been trending lower since the end of March, the price-to-earnings ratio (P/E) has been driving the rally in the S&P 500. Unprecedented monetary stimulus from the Federal Reserve (Fed) and a lower discount rate have clearly helped drive the expansion of multiples, pushing up forward P/Es and equity returns (chart 2).

Does this sound familiar? It should, because back in 2018, when we had no idea what R0 meant, equity markets sold off on the back of increasing trade tensions and a weakening global economy. The Fed then cut rates and the liquidity stimulus supported multiple expansion, driving equity returns higher while earnings barely moved.



How far can multiples go?

P/E multiples suggest that US equities are expensive, with S&P 500 index currently trading on 21.9x forward P/E, which is well above its pre-Covid-19 crisis level of 18x. And this multiple also appears extremely elevated from a longer-term perspective (chart 3). While earnings continue to be an important driver of stock market returns, we think it is important to look at multiple expansions to understand how long the market rebound can last.

We believe that although the fundamental outlook is still weak, liquidity could continue to support stock prices.

We use our US earnings forecasting model to find that the forward P/E ratio could rise even further from its current level, going up to 26.5 in 2021.


How our earnings model works

Our top down approach allows us to forecast the share of profits in GDP via margins and capacity utilisation. While the forecast for capacity utilisation is being driven only by real GDP growth, the margins forecast is affected by growth in labour costs, prices and productivity.

Economic activity has substantially fallen in this first half of the year as a result of the lockdowns, putting severe downward pressure on profits. It seems that US economic activity found its bottom in May, with the recent non-farm payroll report showing unemployment starting to fall from its April peak. Mobility data, high frequency indicators and economic surprises have also bottomed out, providing reassuring signs of an activity rebound.

What we expect on earnings

Although we are forecasting a pick-up in growth in the third quarter, we do not expect pre-Covid levels of activity to have returned by the end of 2021.

Amid the dramatic drop in employment levels and uncertainty around how the pandemic will evolve, we think households will be reluctant to spend and will create a savings buffer. Lower consumer spending is likely to weigh on the recovery, and this could mean weaker growth and a slower recovery for profits. As a result of our U-shaped growth forecast, we expect operating earnings for the S&P 500 to drop 42% year-on-year this year and to rise 22% in 2021.

Consequently, earnings are not likely to fully recover from the coronavirus shock next year, while valuations for the S&P 500 seem expensive and are consistent with a more optimistic V-shaped recovery.

We think this disconnect between the strong equities and the weak economy could persist. Low rates are likely to continue to provide some valuation support for equities, and more cyclical parts of the market can catch up with the strong performance of defensives as the lockdown is lifted.

Value versus growth (and tech)

While the overflow of liquidity and stimulus is part of the explanation of the disconnect between financial markets and the weak economy, it is important to be aware of what is also going on underneath the surface. As we are now fully aware, earnings for equities have fallen significantly, but there have been both winners and losers.

A simple way to observe this is through the divergence between “value” and “growth” companies, or companies that appear attractive from a valuation perspective versus companies with strong growth potential.

In the chart below, we can see that for most of the last decade, value and growth earnings have very much moved in tandem. However, the recent bout of volatility has seen value companies’ earnings more severely downgraded relative to growth companies’. This means that the relative earnings prospects for growth companies now look far superior.


It may not come as a surprise that tech firms have been driving the superiority in earnings prospects for growth companies. Tech represents the biggest sector in the growth index and therefore moves in the sector usually drive the moves in the overall index. This has been particularly true for the strength of earnings in tech, which has been the main bright spot across the major sectors.


One of the main criticisms against tech and growth as a whole was that valuations for these companies looked stretched and indeed the level of price-to-earnings over the last 2-3 years certainly seems to confirm that view. However, following the recent upturn in tech – and therefore growth – earnings, those same forward valuation measures no longer look as expensive.


This essentially means that the liquidity in the system further promotes growth at the expense of value stocks. So long as the market’s addiction to liquidity remains fervent, the case for continuing to back growth stocks still seems to hold.