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Corporate Earnings Powering the Market – Raising Fair Value for S&P/TSX and S&P 500 indices
Supply chain issues and inflation have captured the lion’s share of news headlines and discussions over the last few months. However, in our experience, the more these risks are discussed, the more they tend to be already discounted in share prices. Given the focus rising prices and production problems have received, we would argue that they are well engrained into equity valuations.
Given recent declines we have seen in shipping costs and increased semiconductor production from Taiwan, we may get some reprieve in the near distant future.
We have been very impressed with the ability of many companies across multiple sectors to adapt to this challenging environment and continue reporting record levels of profitability. How long this can last is the key question for investors as it will have a significant impact on the fair value of stock markets. From the vantage point of the Portfolio Advisory Team we believe some bearish analysts may be underestimating the potential length of this economic cycle as there remains a considerable pent up demand for leisure products, cars, electronics, technology solutions, etc. which should extend through 2022 and into 2023.
As an example, while the profitability of car companies is not as high as it would have been in 2021 absent supply issues, their earnings should be higher over the next few years, as consumers on waiting lists finally receive their cars. Longer term, we still think productivity gains (from technology investments in AI, robotics etc.) will help counteract some of the negative impacts of inflation.
Given the continued strength in earnings, we are increasing our fair value estimates for the S&P/TSX and S&P 500 to 26,000 (from 24,000) and 5,000 (from 4,600) respectively. These higher targets are driven by the powerful earnings trends we have mentioned rather than a higher valuation multiple. We continue to favour the Canadian market which we believe should outperform the S&P 500 over the next several quarters.
Inflation in Canada rose to an 18 year high based on the Consumer Price Index reported toward the end of October, however our long-standing conclusion still remains:
“Some inflation has not been a bad thing for the Canadian stock market. Our commodity exposure is a strong positive with energy, base metals (precious metals have a more mixed track record) typically providing a great tailwind to the market. Other sectors, such as Financials (because of higher rates) and Industrials also tend to do well.
In summary, over 70% of the TSX tends to be positively impacted by inflation, especially for companies with pricing power (and given demand trends, many companies have better pricing power now than in the last decade)”.
More details on Current Earnings Trends
According to Factset, for Q3 2021, 82% of S&P 500 companies have reported a positive earnings per share (“EPS”) surprise and 75% of S&P 500 companies have reported a positive revenue surprise.
The blended earnings growth rate for the S&P 500 is 36.6% which is on track to be the third highest (year-over-year) earnings growth rate reported by the index since 2010. Looking to Q4, this is the sixth consecutive quarter in which the bottom-up EPS estimate increased during the first month of the quarter, which is the longest streak since FactSet began tracking this metric in 2002.
The Portfolio Advisory team has written about our positive stance on Energy, Materials and Financials on a number of occasions and those sectors did not disappoint. U.S. Banks in particular have been substantial contributors to the increase in the earnings growth rate for the index since September 30. As a result, the blended earnings growth rate for the Financials sector has increased to 35.0% from 16.8% over this period.
This is good news for Canadian banks (a 21% weight in the TSX) which begin reporting results on the first week of December. Encouragingly, as noted by BMO Canadian Banks Analyst Sohrab Movahedi, in mid-October OSFI released August balance sheet data for the Canadian banks. Overall loan growth was up 5.7% year over year, marking the first month of broad-based growth across all major loan categories since the start of the pandemic. While only one month, this provides a positive indication of how loan growth may be shaping up for the final quarter of F2021 with growth across all the key categories of RESL, Consumer and Business & Government lending.
Manufacturing Activity
The bottom line is that activity continues to expand globally, notably in North America (the all-important U.S. ISM Manufacturing Index came in at 60.8, up from a year ago), the Euro Area, the U.K., Japan, Malaysia and Vietnam. China’s manufacturing activity remains depressed but expectations are for expansion due to lower coal prices, fewer power shortages, and more targeted stimulus.
Technical Analysis – Russ Visch
As the Portfolio Advisory Team’s Technical Analyst, Russ Visch, points out, since the beginning of the year, commodity stocks and mega-cap growth/momentum stocks have driven North American indexes such as the S&P/TSX Composite and S&P 500, however in most other countries major averages have been consolidating in sideways ranges since late spring. In fact, peak-to-trough, many major economies in Europe and Asia corrected 12-15% through the middle months.
We are starting to see signs that this consolidative process is coming to an end, with major upside reversals in the United Kingdom, Germany, France, Japan and Taiwan.
Historically bull markets with broad stock market participation are the most impervious to external shocks. Usually this is with respect to NYSE stocks, but the global breadth of participation is arguably even more important. The improvement we have seen in most G20 nations in recent weeks is perhaps the best evidence that we remain within a healthy recovery, with significant upside potential in the weeks and months ahead.
The recent turnaround we’ve seen in equity markets makes sense from a seasonal standpoint as well. November to January is the strongest consecutive three-month period for both the S&P/TSX Composite and the S&P 500, with the average three-month forward gains for each being 4.33% and 4.31% respectively.
Bank of Canada Moving Closer to Rate Normalization
A more hawkish Bank of Canada (BoC) added significant upside pressure on short-term rates late October as it announced that after gradually reducing asset purchases that were first implemented in 2020, it was now ending its $2B/ week pandemic related quantitative easing and moving into the reinvestment phase; the Bank will maintain current bond holdings by reinvesting maturing securities, representing monthly purchases of between $4B and $5B of Government of Canada bonds.
More importantly, the BoC surprised the market by indicating the potential for the output gap to be filled sometime in the middle quarters of 2022. This is effectively moving forward the timetable for tightening and opening the door for an April rate hike. While economists penciled in April as the first hike, the combination of the BoC’s focus on inflation, the end of QE and the revised forward guidance led the market to price an even more aggressive outcome. Not only have the odds increased of a January move but the short-term yield curve reflects 100 bps in total over the next 12 months.
With the consensus now leaning toward the end-point of the rate hike cycle of between 1.75% to 2% over the next 2 years (back to pre-pandemic levels) and inflation expected to run above target for longer than originally expected, it justifies the recent turmoil in the bond market. The Government of Canada 2-year yields have already started adjusting upward, more than doubling over the last two months. However, longer term rates, while rising above Q1 highs, have not yet experienced the same upward relative thrust.
The debate over whether the higher-than-target inflation rate is sustainable or transitory is still raging, but this has not stopped some central banks, including the BoC from exhibiting concerns that it could be here for longer than previously thought. The BoC is contemplating rate hikes despite downgrading its GDP forecast and at a time when there are clear signs global economic growth is already decelerating. On the positive side, the market may see long-term inflation expectations moving lower, benefiting from earlier tightening. However, on average, real yields around the world have barely budged, remaining primarily negative. This highlights a risk of potential lower growth ahead and a risk of a policy mistake. (hiking too early/ too fast).
Inflation is expected to remain elevated, in part supported by wage gains which should be enough for the BoC to fear inflation expectations becoming unanchored and pressure them into hiking. Real Estate will need to be monitored as higher short-term rates could feed into higher mortgage rates, potentially cooling the sector.
From an investment perspective, we believe the short-term yield curve is already pricing in a fairly aggressive cycle and may offer more attractive investment opportunities to carry at higher yields, especially when compared to current cash rates. A more defensive duration still remains the best positioning as the balance of risk remains to the upside.
If, as the BoC believes, we are 8 to 10 months away from the economic slack being absorbed, it may already be late in hiking rates, and yields may still be too low. However, considering the BoC’s limited success in forecasting the output gap and the potential for further downward revisions to still elevated GDP forecasts, the pressure on long term rates may be reduced.
Please contact your BMO financial professional if you have any questions or would like to discuss your investments.
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