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Market Comment August 2021

Earnings, interest rates, delta variant growth concerns and safe haven gold 

The effects of the pandemic on the economy have continued to diminish, but risks to the economic outlook remain. Progress on vaccinations has limited the spread of COVID-19. However, the pace of vaccinations has slowed, and the “delta” strain of the virus is spreading quickly in some areas. Continued progress on vaccinations would support a return to more normal economic conditions. The positive earnings beat so far can in part justify the high P/E multiples. Revenues are also above expectations which is a bullish sign. In the end of July Fed meeting, investors followed Chair Jerome Powell’s comments about the timing for the start of tapering of the central bank’s asset purchases.

With regard to interest rates, the Fed is set to maintain the current 0 to 1⁄4 percent target range for the federal funds rate “until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time. “Asset purchases have been a critical tool to preserve financial stability and market functioning early in the pandemic and since then have helped expansionary money supply to boost the economy and encourage spending. The Federal Open Market Committee kept interest rates near zero and maintained asset purchases. These measures, along with strong guidance on interest rates and the balance sheet, will ensure that monetary policy will continue to support to the economy until the recovery is complete. Household spending is rising at an especially rapid pace, boosted by the ongoing reopening of the economy and ongoing policy support. The Fed believes it is not timely to raise interest rates now. 

Inflation concerns are moderate and will ease. The Fed’s favored measure of core inflation was seen rising an annual 3.7% in June. This was notably though due to supply shortages. As the economy continues to reopen and spending rebounds, we are seeing upward pressure on prices, particularly because supply bottlenecks in some sectors have limited how quickly production can respond in the near term. These bottleneck effects have been larger than anticipated, but as these transitory supply effects ease, inflation is expected to drop back toward the Fed’s longer-run goal. Powel stated as the reopening continues, bottlenecks, hiring difficulties, and other constraints could continue to limit how quickly supply can adjust, raising the possibility that inflation could turn out to be higher and more persistent than expected.  Yet indicators of longer-term inflation expectations appear broadly consistent with the longer-run inflation goal of 2 percent. 

We are temporarily faced with the particular situation where the market is not at full employment, but there is high inflation. Over the next couple of years there will be progress toward maximum employment. Considering the number of job openings compared to the number of unemployed, the Fed believes we are at the path to a very strong labor market with high participation, low unemployment, high employment, and better wages. Also, there have been very generous unemployment benefits, which are now rolling off and employment will soon increase. 

Forecast-beating earnings have helped fuel this year’s stock rally, but the question is whether it can last or if the optimism has been priced in. End of July tech giants reported earnings including Facebook Inc, Tesla Inc, Apple Inc, Alphabet Inc, Microsoft Corp and Amazon all reported above estimates. More S&P 500 companies are beating EPS estimates for the second quarter than average, and beating EPS estimates by a wider margin. According to FactSet, 91% of the companies in the S&P 500 have reported actual results for Q2 2021 to date. Of these companies, 87% have reported actual EPS above estimates, which is above the five-year average of 75%. It so far marks the highest percentage of S&P 500 companies reporting a positive EPS surprise since 2008. Also, 87% of S&P 500 companies have reported a positive revenue surprise. 

Looking at future quarters, analysts expect earnings growth of more than 20% for the remaining two quarters of 2021. Based on Yardeni research, the index earnings per share are expected at 205 for 2021 which is 25% higher than 2019 and 2018 levels (disregarding the pandemic drop). Positive earnings surprises reported by companies in the Financials, Information Technology, Communication Services and Healthcare sectors have been the largest contributors to the overall increase in earnings for the index since the end of the second quarter.

Revisions are higher, even in revenues. The third quarter marked the marked the fifth straight quarter in which the bottom-up EPS estimate increased.

The blended earnings growth rate for the second quarter is 89.3% today, compared to an earnings growth rate of 88.7% last week and an earnings growth rate of 63.0% at the end of the second quarter (June 30). For CY 2021, analysts are projecting earnings growth of 41.9% and revenue growth of 14.5%.  and for CY 2022, analysts are projecting earnings growth of 9.4% and revenue growth of 6.5%.

The forward 12-month P/E ratio is 21.1, which is above the five-year average and above the 10-year average. That means the earnings yield is 4.7%, well above the 10-year treasury yield at 1.3%, showing there is still little competition to equities from bonds. Treasuries once again came under broad pressure with the curve steepening. 10-year yields briefly crossed above the 1.30% mark.

Earnings revisions have moved higher faster than the index price.

The forward 12-month P/E ratio at 21.1 is slightly below the forward 12-month P/E ratio of 21.4 recorded at the end of the second quarter (June 30). Since the end of the second quarter (June 30), the price of the index has increased by 3.8%, while the forward 12-month EPS estimate has increased by 4.9%. 

The bottom-up target price for the S&P 500 is 4966.47, which is 11.3% above the closing price of 4460.83. At the sector level, the Energy (+22.9%) sector is expected to see the largest price increase, as this sector has the largest upside difference between the bottom-up target price and the closing price. On the other hand, the Utilities (+6.2%) and Financials (+6.7%) sectors are expected to see the smallest price increases

The Conference Board forecasts that US Real GDP growth will rise to 9.0 percent (annualized rate) in Q2 2021 and 6.6 percent (year-over-year) in 2021. Following solid economic growth in Q1 2021 the recovery is expected to continue through the remainder the year. Looking further ahead, economic growth of 3.8 percent (year-over-year) is expected in 2022  which is still well above the 2-3% traditionally healthy GDP growth range.

As the economy fully reopens and consumer confidence rises, consumer spending will help drive the recovery forward – especially spending on in-person services. These outlays will be underpinned by a strengthening labor market and a large pool of savings derived from three rounds of fiscal stimulus checks dispersed over the last year. Furthermore, the launch in July of a new wave of monthly government checks to families with children, worth more than $100 billion, will further strengthen spending in the second half of the year.

However, right now the spread of the delta variant of the COVID-19 virus is taking its toll on confidence. The consumer sentiment index tumbled to 70.2 in its August reading, a figure that is down more than 13% from July’s result of 81.2. The weaker-than-expected consumer sentiment report, drove U.S. Treasury yields sharply lower by (-)5.12% as of now.

Gold prices surged higher following the unexpected decline in consumer sentiment. The decline in confidence immediately weighed on U.S. yields and in turn the U.S. dollar, despite a Reuters poll that shows that most economists believe that the Fed will begin tapering in September. 

Gold is drawing support from the risk-off sentiment, as Asian markets have eased and the dollar is also slightly weaker. A 10-year Treasury yield pull back reduces the opportunity cost of holding non-interest-bearing gold. 

The safe heaven metal though is being seen as a short-term trade rather than a good opportunity to hold longer term.


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