One Time Benefits vs. Long-term Productivity Gains

Many positives exist to take the market higher.  A common refrain is that we are at the beginning of a new economic cycle.  The corresponding improvements in a wide range of economic data and consumer spending is the first step in a 5-10 year bull market.  We agree little exists to stop the market from going higher near-term.  We expect pent-up demand and the multiplier effect of stimulus, with the potential for further additional stimulus, to drive higher consumer spending and corporate earnings.  This may carry into 2023, potentially continuing earnings growth for S&P 500 companies. 

As a result, risks are really centered on materially slower than expected economic and earnings recovery, and/or the ever present unknowable categorized as a black swan.  Expanding valuations are a poor timing tool until fear starts to increase, usually driven by real risks to earnings and profitability.  So, our question is how much earnings growth is the result of one-time benefits (e.g., pent up demand, stimulus) versus productivity improvements.  The latter is a significant long-term driver in global economic growth and higher standards of living that benefited many people over the past centuries.  Thinking about it another way – one-time benefits produce a bigger slice of pie, while productivity improvements produce a bigger pie for everyone to share a larger slice.

The difficulty is that productivity is hard to measure, and generally takes a long-time (decades) to play out.  At times, however, the acceleration of innovation and global changes in behavior (e.g., the pandemic) can result in step function increases in productivity.  Improvements in this metric would help support the argument for starting a new business cycle and a corresponding multi-year bull market.

Factors that support productivity improvements include:

1. The S&P 500 EPS CAGR from 2016 to 2022 is 8.6%, consistent with historical earnings growth for the index.  Estimates for 2022 only forecast 6% EPS growth since 2019, suggesting upside exists to estimates. 
2. Conversion of commuting time into more productive uses.  The average American spends over 200 hours annually commuting and Europeans likely spend even more time.  More effectively using this time should contribute to growth.
3. Moving more work online can improve some business processes, accelerating a trend that has been in place for decades.

Factors suggesting one time benefits that will make earnings growth in out-years (2023 and beyond) more challenging include:

1. The EPS growth CAGR from 2016-2022 is only 8.6%, including tax cuts, some of which may be reversed, and significant stimulus.  This implies productivity may not have increased much. 
2. Surveys and anecdotal reports suggest many people are working more hours during the pandemic due to lack of recreational activities.  This likely reverses as the economy re-opens. 
3. Remote work can reduce collaboration and idea sharing between groups, inhibiting R&D and new ideas to drive future productivity improvements. 

For now equity markets appear poised to go higher as investors seem to favor the bull case.  It makes sense to take advantage of the optimism, and likely solid returns, because risk exists that we are borrowing returns from the future. 

Bar Chart of S&P 500 Earnings with Estimates for 2021-2022

Sector Outlook

Within equity sectors, we continue to like Technology due to long-term growth opportunities, and Healthcare due to company specific innovation and valuation trends.  Given early cycle recovery trends, we also moved Industrials overweight.  We remain underweight Energy due to long-term value destruction, though recognize it may rebound near-term as economies reopen and demand increases.  We also remain underweight Communication Services due to legacy media companies and believe REITs will continue to trade inline to below the S&P 500 with greater volatility.

Technology valuations continue to trend higher.  Nevertheless, we expect tech spending to increase meaningfully in 2021 (up ~5%y/y) after lagging in 2020 due to lower corporate revenue and corresponding operating expense constraints.  This will play out differently in the subindustry groups as software proved more resilient in 2020 with higher valuations and tougher comps in 2021, compared to hardware.  We expect continued migration to the cloud to drive further IT productivity gains and solid overall sector earnings growth. 

Industrials are well positioned to benefit from increased capex spending and automation improvements as manufacturing companies look to improve production line resiliency.  We expect short-cycle industrials to benefit first, followed by long cycle, with commercial aerospace likely the last to recover. 

Health Care remains attractive given its innovation driven growth and reasonable valuation.  Health Care (particularly Pharma) has a chance to emerge from the outbreak with a better public image as companies have rallied to fight the virus.  Reimbursement pressure likely remain a headwind, but the sector has repeatedly overcome these pressures while improving overall healthcare treatments and outcomes. 

We remain underweight Communication Services given the lack of solid dividend candidates within the challenged media industry.  In contrast, Google and Facebook remain well-positioned for long-term growth.  We expect continued regulatory risk, and for now, view large sell-offs in these stocks as opportunities to selectively add to positions. 

While underweight Energy, we acknowledge a cyclical rebound likely takes the stocks higher near-term on increasing demand and rising oil prices.  Given the small weight (2.5%) of the sector, we are selective with individual stocks as depressed sentiment is offset by management teams’ destruction of capital (though we are seeing indications this may be improving) and the sector’s long-term growth headwinds.  We still believe underinvestment over the past 5-10 years has the potential to create significant under supply and large price increases.  However, it is difficult to project how much the stocks may benefit given increased focus on ESG investing.

We remain underweight Real Estate on potential yield curve steepening, which would raise costs, as well as longer-term concern for commercial real estate demand. 

We moved Financials to neutral given the prospects for some yield curve steepening on higher inflation expectations.  We remain neutral on Consumer Discretionary, Staples, Utilities, and Materials.  We acknowledge the Materials sector likely benefits near-term from the cyclical rebound and are sticking with a couple of longer-term holdings that we believe remain well-positioned rather than chasing different stocks in the sector.

Despite commentary that Equities are overvalued, we believe the risk/reward is relatively balanced given the available data.  Earnings likely continue trending higher for another 6-18 months on stimulus and pent up demand.  We can make strong arguments that S&P 500 companies can continue gaining share and investors have limited opportunities for returns in other asset classes, so the index continues to move higher.  We recommend clients work with their Relationship Manager to develop comprehensive financial plans, and to stick to the plan through the future market volatility that will inevitably occur.