By almost any measure, this has been an astonishing earnings season for US corporates. At the time of writing, around two-thirds of companies had beaten expectations – and not just by a little. Barclays analysts put average earnings per share growth at an impressive 63%. However, it doesn’t appear to be having much impact on share prices. Why?
Tesla is a case in point: its earnings rose to 93 cents per share, against expectations of 79 cents with revenue up 79% year on year. Its share price dropped 3% in the immediate aftermath of the results. Overall, the S&P 500 has been treading water even as results have come through strongly.
The strong macroeconomic picture is also not providing the support it should. The US economy is flying. Retail sales registered almost 10% growth year on year in March. The IMF is predicting GDP growth of 6.4% for 2021. Manufacturing is seeing huge expansion and jobs growth is buoyant.
Steven Bell, chief economist at BMO Global Asset Management, says there is more to come. “The excellent vaccine rollout plan is unleashing a surge in spending as consumers emerge with bank accounts bursting with cash from a whole series of fiscal handouts,” he says.
Style rotation is muting the big tech names
There are a number of factors keeping US markets subdued. The first is a style rotation. The big tech names make up a disproportionate chunk of the major US indices. As such, their weakness weighs heavy on overall market performance.
Nick Ford, fund manager on the Premier Miton US Opportunities and US Smaller Companies funds, says: “We are seeing a classic case of sector rotation as investors bank the gains made last year (huge in many cases) to reinvest in companies that will benefit from the reopening of the economy.
“Investors have recognised there is huge pent-up demand for goods and services unavailable during lockdown (cruise vacations, eating out etc.) and economic growth is likely to be extremely strong as president Biden’s stimulus plan is rolled out.
“So the best performing stocks have been domestic cyclicals such as retailers, consumer goods companies, basic materials and banks. The latter is benefitting from higher interest rates which will make lending more profitable.”
Other reasons to be cautious
However, there are also other concerns. Bell says that much of the good news is already priced into US markets. He points to Goldman Sachs research that shows markets are often weak when the ISM manufacturing index is at its highest. Why? “Markets do well when news flow is improving and with recent data so strong, there is a chance that upcoming releases will disappoint. Momentum is peaking.”
There’s another reason to be cautious. President Biden’s infrastructure bill brings $2.3trn of extra spending, to be balanced by $1.6trn of tax rises. The tax rises are likely to come in earlier than the extra spending, so fiscal policy may be a drag on the economy by the end of the year.
Bell says that while markets have been focused on corporate tax rises being lower than expected (25% rather than 28%), there’s a raft of other corporate taxes going up in the bill, which aren’t factored into current market pricing.
“If analyst estimates haven’t factored in tax rises. And investors have grown used to companies beating estimates by huge margins, it’s unlikely that they’ll be forgiving if this pattern begins to reverse.”
Inflation and corporate debt are other worries. US inflation has been ticking higher and companies are reporting mounting inflationary pressures caused both by Covid-related bottlenecks and rising commodity prices.
Ford says: “Inflation is the number one worry for investors, particularly fans of growth stocks. If inflation gets out of control, the Federal Reserve will have to raise interest rates to combat it and growth stocks become less valuable when bond yields rise.
“Recent inflation data has been slightly stronger than expected. The question is whether this is a temporary phenomenon or structural – we do not know yet.”
He believes corporate debt, while high, is an issue for further down the road: “Corporate debt has not been a major worry because companies have been able to raise equity of refinance debt fairly easily.”
Where does this leave US equities?
Certainly it gives headwinds for technology companies, in spite of their strong earnings. Nevertheless, there are parts of the market that have been left behind.
Ford says: “We think we are at the start of a major period of outperformance from the smaller companies sector which has been shunned by investors in recent years as a result of the popularity of mega cap technology stocks such as the Faangs. When fund managers notice that the Russell 2000 Smaller companies index is consistently beating the S&P 500, the pressure to get involved will go up.
“Given that smaller companies have less trading liquidity than large, the move up in share prices can be dramatic when large buyers show up.”
Another big question for investors is whether this will halt the long-term outperformance of passive funds in the US market. Many investors access the US market through an S&P 500 tracker. That may not prove the best solution for the current market conditions.
