Despite the near-term uncertainty posed by the resurgent virus, we remain encouraged by the economic recovery that is being supported by the labor market and healthy corporate profits.
While we are most likely past peak economic and profit growth, economic indicators remain favorable that should support future profits that are key to further stock gains.
Leading Indicators Stay Strong, but Point to Peak Growth: The Conference Board’s Leading Economic Index (LEI) registered another large gain in July with all 10 of its components making positive contributions, led by credit and ISM new orders. The Leading Index’s overall upward trend, which started with the end of the pandemic-induced recession in April 2020, is consistent with strong economic growth in the second half of the year. However, on a year/year basis, the LEI is off its peak rate of change, which suggests we are past the peak of the economic expansion.
Initial Jobless Claims Consistent with Healing Labor Market: Initial claims for unemployment insurance fell 29,000 last week, its fourth consecutive decline, to 348,000, another pandemic low, and below the consensus of 360,000. After stalling for about two months, the four-week average of claims resumed its decline, falling to 377,750—its lowest level since March 2020. The improvement in weekly jobless claims is consistent with other labor market indicators that show the labor market continues to heal. We expect further progress this fall as kids go back to school and the supplemental federal unemployment insurance expires on September 6.
Observations from Earnings Season: While second-quarter earnings had very easy comparisons with last year when the economy was shut down, it was nonetheless an impressive season. S&P 500 quarterly earnings grew 93% year/year, and sales increased by 23.5% year/year compared to the same quarter a year ago.
Looking through last year’s weak second quarter, second-quarter 2021 earnings stand 29% above the second-quarter 2019 level, which translates into 14% annualized growth. 87% of the companies have beaten both sales and earnings expectations with the earnings surprise 16% and the sales surprise 4.6%. The magnitude of these beats is unprecedented at more than two standard deviations above the historical average. This suggests estimates were too low with the pandemic and response to it creating uncertainty that led to conservative company guidance.
Looking at the results from a sector perspective shows a rebound for the cyclical sectors. Industrials, Consumer Discretionary, Energy, Materials, and Financials all delivered triple-digit earnings growth, and double-digit sales growth.
Looking forward, earnings per share is expected to grow at 17% over the next 12 months for the market as a whole, according to IBES. While this is still a healthy growth rate, it indicates that we are past the peak in earnings growth for this cycle. Cyclical sectors are expected to grow the most over the next 12 months. Energy is expected to lead with 87% growth followed by Industrials (46%), Consumer Discretionary (40%), Communication Services (18%), and Materials (17%). The sectors with earnings growth expected to be below the market include Technology (12%), Health Care (9%), Financials (9%), Consumer Staples (7%) and Utilities (5%).
We continue to expect the economy and profits to be well supported by a healthy consumer with estimates showing excess savings standing at about $2.5 trillion. There are currently 10.1 million job openings which suggests further labor market gains ahead in the coming months that will also support consumption. While we view Technology and Health Care as core holdings, we think the cyclicals remain well positioned for recovery.
Spending on goods had exceeded its historical trend during the pandemic and has recently weakened, but spending on services is still below pre-pandemic levels. Despite the resurgent virus, we think service spending will continue moving higher with hotels, restaurants, and leisure well positioned for future gains.
Even after triple-digit earnings growth in the second quarter, Industrials earnings are still below pre-pandemic levels. Significant pent-up demand still exists, while inventories are historically low, suggesting a positive backdrop for the sector. Energy capital spending remains well-disciplined and the sector should benefit from further demand growth. Communication Services also has secular characteristics and benefits from rebounding advertising expenditures.