The Profit Engine That Could

2020 Offered Mounting Challenges for Earnings

By DAVID LEBOVITZ/Guest Contributor

The silver lining of quarantine has been time spent with my young daughter. Every night we go upstairs to her room, sit in a large arm chair, and read a selection of books. One of her favorites is "The Little Engine That Could." In this story, a tiny steam engine pulls a broken-down train up and over a mountain. As the tiny engine climbs the mountain, it repeats the mantra “I think I can, I think I can,” and eventually succeeds in getting up and over the hill. On the way down, the engine repeats to itself “I thought I could, I thought I could,” as it descends toward the town below[1].

Similar to the little engine, investors in 2020 recognized the challenges posed by the pandemic, but believed that with patience, policy support, and a bit of optimism, they would eventually get to the other side. The final earnings reports of 2020 are now being delivered, and the investment community can shift its focus from climbing the mountain to the descent. S&P 500 operating earnings appear to have fallen by about 20% in 2020, far better than the 31% decline that was projected at the end of the second quarter. Looking ahead, a more favorable starting point, robust economic growth, a weaker dollar, and higher oil prices should push 2021 S&P 500 operating earnings to a new all-time high.

Questions remain about the evolution of monetary and fiscal policy, higher taxes, vaccine distribution, and virus mutation. In general, however, a backdrop characterized by improving growth and easy policy should support U.S. equity performance over the next twelve months. There will be periods of volatility, but we do not expect a repeat of early 2020. One of the things that roiled markets at the beginning of last year was a lack of information about the pandemic, and specifically, its impact on corporate profits. However, corporate guidance in the form of earnings revisions started to return into year-end; if this trend continues, it should afford investors more clarity on profits in 2021.

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I thought I could, I thought I could

One of the remarkable things about 2020 was the speed with which earnings rebounded during the second half of the year. This was primarily a function of profit margins; sectors like technology, health care and consumer staples saw resiliency in margins as they aggressively cut costs in the face of slowing economic growth. On the other hand, companies in the more cyclical sectors saw margins decline sharply, but then bounce strongly, as revenues rebounded and costs were contained. This stands in sharp contrast to the experience of the financial crisis; profit margins began to decline in 4Q06, fell to zero in 4Q08, and did not hit a new high until 4Q13.

Although margins across the board remain below prior peaks, technology and health care are close to making new highs. However, there is considerable room for improvement in the more cyclical sectors. It seems reasonable to expect that the combination of additional stimulus and a rebound in economic growth will allow for margin expansion, pushing earnings to a new all-time high of $168 by the end of this year.

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However, there are two risks on the horizon. The first is higher taxes. It is not entirely clear whether Congress will increase corporate tax rates this year, but we recognize that it is on the Administration’s agenda. An increase in the corporate tax rate to 28% would weigh on margins and overall profitability; assuming this occurs next year, it would be reasonable to expect a $9 hit to S&P 500 operating earnings in 2022[2].

The second risk relates to the evolution of the economic environment. As the rebound fades and we return to trend growth, economic activity will slow and wages will rise. This will weigh on revenues and boost costs, pushing profit margins lower.

Investment implications

As the pandemic began, recency bias led investors to embrace parts of the equity market that had worked well during the prior expansion. This created a handful of winners, a fair number of losers, and pushed S&P 500 valuation dispersion to its widest range in more than 25 years. 

As a result, 2021 is a year to be active. We forecast an environment of accelerating economic activity and rising interest rates, which should support more the more cyclical and value-oriented sectors of the market. Of course, given the solid outperformance of these cyclical names over the past few months, many investors are asking if this trade has run its course.

Our answer would be no. The relative performance of value and growth tends to track the spread between the Federal Funds Rate and the 10-year U.S. Treasury yield[3]; although the curve has steepened as of late, value has only begun to catch up relative to growth. Furthermore, the Federal Reserve has been quite clear that policy normalization will be a process that starts with the tapering of asset purchases and gradually extends to raising rates. This points to a steeper curve as the Fed Funds rate remains anchored at zero and long rates drift higher.

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For years, investors have been looking for value to outperform growth, citing attractive relative valuations. While we acknowledge that value remains cheap relative to growth, this is only one piece of the story; the key is to identify assets that are attractively priced and look set to outperform in the expected macro environment. Value has historically outperformed growth during periods of accelerating economic activity and a steeper yield curve; as such, it will be important for investors to have sufficient value exposure in portfolios during the coming year. 

Sources: 

[1] Piper, Watty. The Little Engine that Could. First published 1930.

[2] Assumes average earnings growth of 8% in 2022 and an effective corporate tax rate of 25%.

[3] The exception is the Financial Crisis, when strength in the energy sector allowed value to outperform.

About the Author: David M. Lebovitz, Executive Director, is a Global Market Strategist on the J.P. Morgan Asset Management Global Market Insights Strategy Team. In this role, Lebovitz is responsible for delivering timely market and economic insights to clients across the country. He helped build the Market Insights program in the United Kingdom and Europe, has appeared on both Bloomberg TV and CNBC, and is often quoted in the financial press. Lebovitz first joined J.P. Morgan in 2010. Prior to joining the firm, he was a Research Analyst at Kobren Insight Management. He obtained a bachelor's degree in Political Science and Philosophy, with a concentration in Leadership Studies, from Williams College in 2009. He earned a dual-MBA degree from Columbia University and London Business School in 2015.  

J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. Visit www.jpmorgan.com/institutional for more information.

JP Morgan is an Associate Advisor member of TEXPERS. The views expressed in this article are those of the author and not necessarily JP Morgan nor TEXPERS.

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