The second quarter displayed strong GDP growth around the developed world as economies were reopening after the lockdowns and the vaccination programs gathered pace.
GDP growth was exceptionally strong in the eurozone, where it reached 2% growth quarter-on-quarter exceeding expectations markedly. Eurozone grew faster than China, that has not been seen quite often. Many of the hardest hit countries such as Italy and Spain grew faster than expected, but Germany was lagging behind the forecasts. Bottlenecks in the supply chain of materials and intermediate goods like metals and semiconductors were holding back growth in the German manufacturing sector, where carmakers were showing weakest development.
In the US the second quarter GDP growth was at 1.5% quarter-on-quarter, which was, at first glance, somewhat of a disappointment. Looking more closely, the US growth looks more robust. Private consumption, especially service consumption contributed strongly to the GDP. The fall in inventories cut off GDP growth substantially for the second consecutive quarter. This may be related to restrictions in the supply chains. Going forward, this implies, that the stock of inventories needs to be restored, which will boost GDP growth in the coming quarters.
The second quarter corporate earnings season has been quite exceptional both in the US and in Europe. As the reference point for the second quarter figures is the weakest quarter in the midst of the first wave of the pandemic in 2020, huge earnings growth was expected. Qualitatively the outcomes seem very similar, which is not that surprising, as both markets are recovering from a similar shock to the economy.
In the US, FactSet reports that when 89% of S&P 500 companies have now released the second quarter results, earnings growth year-on-year stands at 89%, a highest figure since the aftermath of the Great Recession in 2009. The 5-year average earnings growth for S&P 500 companies is 7.1%, which reveals how exceptional this quarter is.
In Europe, data about STOXX 600 companies provided by Refinitiv shows a brisk earnings growth of 140% in the second quarter, when actual results are currently released by around 60% of the companies in the index. Excluding the energy sector, the growth is still at 99%.
Both in the US and in Europe companies are reporting earnings that are around 20% higher than analysts’ expectations. What is also similar is that the strongest rebounds in earnings are displayed in cyclical sectors benefitting from economic recovery such as industrials, consumer discretionary, basic materials and energy sectors.
Earnings optimism have pushed equity prices higher and volatility indicators are at the low levels. Both in the US and in Europe major stock indices have reached record high levels. Going forward, after this record earnings season it will be challenging to impress the ever-forward-looking financial markets.
What kind of support from the macroeconomy to corporate earnings one can expect during the coming quarters? International Monetary Fund revised the GDP forecasts for both the US and eurozone upwards in July. The Fund sees the US economy to expand by 7% this year and around 5% next year, whereas the eurozone would reach a growth rate around 4½% in both years. These are high figures for GDP growth and will hold only if no major setbacks emerge.
Simple calculations illustrate what these IMF figures imply for the eurozone growth. When taking into account the stronger-than-anticipated growth in the second quarter, which was published after IMF raised the eurozone forecast, the eurozone still needs around 1.5% quarter-on-quarter growth in the third and fourth quarters to reach IMF’s growth estimate for this year. This is not impossible, provided that the recovery continues without being interrupted by new variants of coronavirus or any other major disturbance to economic activity. But eurozone would probably need to outpace China again to reach these figures. In normal times the eurozone quarterly growth rate is only around 0.3% at best.
Both in the US and in Europe analysts’ earnings growth estimates fall substantially starting from the third quarter, displaying still robust 21%-42% growth rates year-on-year and bringing the whole year 2021 estimates to a range of 42%-52%.The slowdown in earnings growth in the latter part of this year is quite expected and stems from higher reference points for earnings comparisons during the second half of year 2020.
For the fiscal year 2022, earnings growth estimates approach normal levels after the strong rebound from the lows of the pandemic in 2021. For year 2022 analysts’ projections stand at 9.5% for S&P 500. This is close to the standard assumption of 10% earnings growth, which is typically the starting point for anew fiscal year. For STOXX 600 in Europe, current estimates for the first and second quarters are meager at the range of 2%-3%.
Corporate earnings tend to swing a lot with economic activity, as a large share of companies’ expenditures are of fixed nature or difficult to adjust due to social norms. Difficulties in optimizing the workforce in face of demand fluctuations is an example of the latter. Hence, the growth outlook is an important factor for corporate earnings at the aggregate level.
What are the main short-term worries for GDP growth in the US and in Europe? The consensus projections, such as the IMF’s forecast, paint a rather positive picture. The resurgence of new contagious variants of the coronavirus may, however, surprise societies and force for a re-evaluation of the coronavirus policies. In developed countries, where vaccination programs proceed and the share of fully vaccinated people is steadily increasing, it seems unlikely that full-blown lockdowns would be introduced anew. However, some regional restrictions on gatherings, restaurants and travel might be reinstated.
Another worry relates to supportive economic policies being cut too soon. Fiscal policy both in the US and in Europe has been very loose during the pandemic, which has led to ballooning public debt. The withdrawal of pandemic-related stimulus measures like enhanced unemployment benefits in the US and scaling down support programs for struggling companies in Europe have raised concerns about too rapid fiscal tightening. The rapidly increasing debt is, however, a problem of its own. And the lavish support for the unemployed in the US have most likely kept people from applying jobs and contributed to the tightness of the labour market.
The possible profit squeeze stemming from lower GDP growth might this time be associated with rising costs due to surging material prices and, in particular, due to higher wages. Higher material prices are already putting pressure to profit margins in many industries. Bottlenecks in labour market are widely reported, and problems in hiring both skilled and unskilled workforce might tighten the labour markets and eventually lead to higher wages.
Those companies, which manage to protect their profit margins and pass on higher costs and higher wages to their selling prices, will fare better in any circumstances. How to identify beforehand these companies having pricing power, the answer would be worth a lot to any investor.
Why all the fuss about corporate earnings? Well, they constitute the foundation for equity valuations. The near-term outlook for the US and the European economies looks rather benign, and it should support equity markets. Profit squeeze from weaker-than-expected GDP growth accompanied with rising costs and wages is the main worry for equity markets. The current listed equity valuations on both sides of the Atlantic are rather stretched with the S&P 500 12-month forward P/E ratio at 21.1 and the corresponding STOXX 600 ratio at 16.8, both well beyond the 10-year averages of 16.8 and13.9, consecutively. So, with these valuations, even slightly disappointing earnings results down the road could trigger re-pricing and a correction in the equity markets.
Can we be sure about something in this inherently uncertain world? The answer is yes. Central banks, that is, the Fed and the ECB will not take away the punch bowl just as the party gets going. This means that central banks will not tighten their monetary policies prematurely and suppress the growth. On the contrary, they will offer support for ailing economies through further stimulus measures for an extended period of time, if deemed necessary. This would obviously be positive for corporate earnings and equity valuations in the near-term. What would be the long-term implications of such monetary policy, that is a topic for another Ermitage blog!
Senior Advisor, Chief Economist