Wei Li, Global Chief Investment Strategist at BlackRock Investment Institute together with, Elga Bartsch, Head of Macro Research and Kurt Reiman Senior Strategist for North America, both forming part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
Strong earnings growth is due to the strong economic restart – and the realization of such strength was priced in by higher multiples last year as stocks surged back from the Covid-19 shock. We are likely to see earnings growth normalize as activity settles after the powerful restart. Historically high earnings beats are partly due to conservative guidance. We see near-term upside to that guidance and expect it to help support equities – and stay tactically pro-risk amid very low real rates.
Past performance is no guarantee of future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv, October 2021. Notes: The bars shows the 12-month total return of the MSCI ACWI Index into dividends, earnings and multiple expansion. Earnings growth is based on 12-month change in 12month forward I/B/E/S earnings estimates.
Companies representing more than half of the S&P 500 Index market value have reported third-quarter earnings. Over 80% of them have beaten expectations on profit and more than three quarters have exceeded revenue estimates. These beat rates are slightly below the elevated levels of the past few quarters but well above long-term averages. Multiples surged last year as investors eyed the strong rebound from the Covid-19 shutdowns – and earnings growth has delivered in the powerful economic restart. Multiples have since declined slightly, but that only reflects that markets had priced in this earnings strength and would be less responsive to the actual outcome compared with a typical business cycle recovery, in our view. See the chart above. The U.S.-led restart means activity will start settling back into more typical, if still-strong levels – supported by ample household savings. Markets may overreact to earnings normalizing as we get beyond the restart bump, and supply chain disruptions will likely remain a challenge. But we would caution against reading too much into such a negative reaction. The fact that U.S. equities have still been scaling all-time highs suggests markets may be prepared for the downshift in earnings momentum.
We believe the bulk of the restart-fueled earnings surge is behind us, and a moderation of earnings growth into next year is to be expected. The restart can only take place once. Yet companies may well continue to exceed earnings expectations, in our view. The earnings revisions ratio – the number of companies with upward revisions versus those with downward revisions – remains in positive territory and is now higher in Europe than in the U.S. We are overweight European equities and neutral U.S. equities as the restart broadens beyond the U.S. – and this feeds into expected corporate earnings.
It’s not a surprise that we’ve seen more mentions of supply constraints and cost pressure, but the overall picture is not as pessimistic as feared. S&P 500 profit margins have dipped but remain above historical averages. We see margins holding up: Companies have showed their ability to manage inflation and to pass higher costs on to consumers. The pent-up demand unleashed by the restart will support revenue and profitability. Markets have punished companies failing to meet earnings estimates or guiding down future results while giving little reward to those with earnings beats. This may encourage companies to be more conservative in their own profit guidance – and create more near-term upside.
We prefer to look at valuations through the lens of earnings risk premium (ERP) rather than multiples, adjusting for the structural decline in interest rates. This is especially true in our new nominal theme that the response of central bank policy and nominal bond yields to higher inflation will be muted compared with the past. That’s underpinned by historically low real yields – a positive for risk assets. Even with the spike in short-term yields across major economies due to a surprisingly hawkish shift by some central banks, including the Bank of Canada last week, real yields remain at or near record lows in negative territory. We see nominal and real yields rising from here but remaining historically low. The European Central Bank pushed back against the market pricing of rate hikes last week, but not enough to change the trend. The risk is of further confusion about the current inflation environment, supply shock and what the monetary policy response will likely be. Eyes are on the Federal Reserve meeting next week – and we expect pushback against current pricing on the policy path.
The bottom line: We still see above-trend U.S. earnings growth even as its pace is moderating as the restart runs its course. The broadening restart and low real rates support our tactical pro-risk view. We prefer European equities where the earnings restart bump is catching up to the U.S. Within the U.S. we prefer quality shares.
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of Oct. 28, 2021. Notes: The two ends of the bars show the lowest and highest returns at any point this year to date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are, in descending order: spot Brent crude, MSCI USA Index, MSCI Europe Index, ICE U.S. Dollar Index (DXY), Bank of America Merrill Lynch Global High Yield Index, MSCI Emerging Markets Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index, Refinitiv Datastream Italy 10-year benchmark government bond index, Refinitiv Datastream Germany 10-year benchmark government bond index, Refinitiv Datastream U.S. 10-year benchmark government bond index and spot gold.
U.S. stocks rallied to all-time highs on robust earnings while European shares climbed near record peaks. Short-term yields spiked after a surprisingly hawkish shift by the Bank of Canada last week prompted investors to sharply pull forward when it might lift policy rates next year. We think the broader market pricing of higher policy rates is overdone – both in how soon key developed market central banks may lift rates and how quickly they will do so. Euro area GDP data showed economic activity is now close to its pre-Covid level.
- Nov 1 – U.S.. China manufacturing purchasing managers’ index (PMI)
- Nov 3 – Fed policy meeting; China, U.S. services PMI
- Nov 4 – Bank of England (BoE) policy decision
- Nov 3 – U.S. nonfarm payrolls
Market attention this week will be on the Fed and BoE’s policy decisions. The Fed is likely to announce to start tapering its asset purchases and to push back on market pricing of multiple rate hikes as soon as next year. We do not expect a lift-off in its policy rate until early 2023. The BoE could become the first major developed market central bank to raise its policy rate since the pandemic hit.
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