Why profits are in the driving seat for US equity returns this year

The recent rise in US 10-year Treasury yields is signalling that investors are becoming more optimistic about the US economy.

Abundant fiscal stimulus, a successful vaccine rollout and looser social restrictions in the US are all pointing to stronger economic growth in 2021 and 2022. However, higher yields are raising concerns for equity investors as they have the potential to drive up borrowing costs for consumers and businesses, thereby weighing on risk assets.

The rise in yields could start dragging on equity multiples and therefore equity returns, but this is only one part of the story.

Earnings will play a crucial role in determining equity returns as stock prices will be driven by the real state of the economy and its corporate sector. After the severe deterioration in earnings due to lockdown measures and the subsequent halting of economic activity in the first half of 2020, companies’ revenues and earnings started to recover in Q3, driving up US market returns.

As shown in the chart below, last year’s returns were mainly driven by multiple expansions. This year instead, we think equity investors should expect earnings per share (EPS) growth amid price-to-earnings (PE) compression.


S&P equity returns will be supported by sound fundamentals as economic surprises, which measure the performance of the economy versus expectations, have been running at elevated levels while earnings have started to improve. This was confirmed by the strong results in the Q4 earnings season as S&P500 listed companies delivered large surprises, surpassing estimates by 17%. More importantly, they raised management guidance which has helped 12-month forward EPS estimates to rise.

This quick turnaround in earnings was not expected as US profits have proven to be more responsive to fiscal stimulus than other parts of the economy, for example employment. While the US economy still has 10 million fewer jobs than before the pandemic, the profits share of GDP has quickly bounced back and is now at a six-year high (chart 2).


Our top down approach allows us to forecast the share of NIPA profits (profits in the national account data) 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. Our forecast model suggests that the profits share could increase in the coming quarters as improving virus dynamics mean that the reopening of the economy is likely to continue.

Looser social restrictions are likely to reactivate large amounts of spare capacity in the economy, especially in the service sector. Lower economic uncertainty could also lead consumers to run down their savings buffers, further boosting domestic demand. Margins are likely to be supported as labour costs will likely decline due to stronger productivity. Wage pressures are also likely to remain subdued as the unemployment rate is not expected to reach its long-term equilibrium level before the second half of 2022. Our model suggests that before-tax profits are expected to rise more than 30% y/y this year and by almost 10% in 2022.

What we expect on earnings and multiples

Corporate profits data from the national accounts differs from the S&P500 data because NIPA measures profits across the whole economy, including private and publicly listed companies, thereby giving a more comprehensive picture of corporate financial health. Moreover, earnings per share for the S&P 500 large cap US equity index are more volatile than the top-down profits. This is because of leverage and write-offs. However, NIPA profits tend to be a good predictor of the EPS for the S&P 500 large cap US equity index as the two indices are directionally similar.

As we forecast a strong rebound in US economic growth, operating earnings of the S&P 500 are expected to rise. The economic recovery will extend into 2022 as it will take some time for the service sector to fully rebound from its pandemic lows. This will provide further support to earnings, which are forecast to grow 8.3% y/y in 2022 following growth of 29% in 2021.

While the fundamental outlook is improving, valuations are not likely to meaningfully deteriorate. Rising yields are likely to pose downside risks to expensive valuations, but not to cause a sharp de-rating. The Federal Reserve (Fed) remains in dovish mode as there is still a large amount of spare capacity in the labour market. Our view is that interest rates will be left unchanged over the next two years as inflation will not rise persistently above the bank’s target of 2%, as discussed in our latest Economics and Strategy Viewpoint.

Assuming prices are held, higher earnings mean a modest decline in equity multiples. Our forecasting model suggests that the forward PE ratio will marginally decline from 18.4x in 2020 to 17.5% in 2022. After a year driven by multiple expansion, we think US equity returns will be supported by stronger earnings.


What are the main risks?

The outlook is very dependent on the path of the Covid-19 virus and the success of the vaccine roll-out. Economic growth expectations have mainly risen due to the discovery of Covid-19 vaccines. If they prove to have no efficacy against new variants, there is a large potential for disappointment with important implications for markets. In our “Vaccines fail” scenario we expect operating EPS to drop 6.2% in 2022 as the world economy experiences a pick-up in cases and renewed restrictions in Q4 2021.

A more persistent rise in inflation is another key market risk. Higher and sustained inflation would lead the Fed to signal an earlier tightening of policy than markets are expecting. Bond yields would rise significantly hitting risky assets and causing a sharper downturn in global activity. In this scenario we forecast S&P 500 EPS to grow by just 1.5% y/y in 2022.

The views and opinions contained herein are those of the author on this page and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.