Recovery and digital leap boosts to S&P EPS are peaking: Are price hikes next?
This earnings season, we expect S&P 500 companies to beat analyst earnings estimates by more normal amounts; by roughly 5% in aggregate, not 20%+ like the last 5 quarters. We also expect the giant leaps in sequential quarterly earnings per share (EPS) of the past 5 quarters to stop. As 3Q21 S&P EPS will most likely be flat or slightly above 2Q21 S&P EPS of nearly $53. While growth rates from a year ago will still be high, given pandemic slump comparisons, investor focus is on sequential quarterly growth in 2021 to help shape the 2022 outlook.
It’s normal for 3rd quarter S&P EPS to be flat or just slightly above 2nd quarter, but US gross domestic product (GDP) growth should be at a 3-5% annualized pace in 3Q, well above 2-3% norm, as demand for services hit by the pandemic made recovery progress and goods demand stayed strong. Despite this favorable macro backdrop, profit growth was challenged by costs owing to many recovering service businesses operating sub scale and higher material costs or lack of availability at goods businesses. Both reported labor cost and availability challenges.
Higher costs put “fair” price hikes in play, but it’s very risky to raise prices
Many companies have raised prices this year and are contemplating further hikes. While instances of pandemic and then reopening induced lopsided demand gave some select enterprises bonafide pricing power, most firms are raising prices in response to higher direct costs and lower capacity utilization or fixed cost spreading. Such price hikes, while fair, don’t boost profits; yet risk damaging customer demand on affordability or sending them in search of alternatives. Thus, a firm raising prices because it must, even if initially successful, still faces higher cost related risks. A business raising prices because it can, on a windfall of luck, is subject to changing winds or might create future competition problems by raising an attractive price umbrella. In our view, it’s not a good sign when a firm must or chooses to “take price”. Unless raising prices from levels deliberately set unsustainably low to accelerate adoption, raising prices to meet costs or especially if to boost profits strains the engine of a business. Price hikes might yield fast profits, but it’s mixing nitrous into the fuel line; it will damage the engine of an enterprise by disappointing customers and encouraging competitors. We generally prefer companies not experiencing acute cost pressures and with good volume growth absorbing unit fixed costs.
Taking price (raising price) differs from price taking. Fluctuating commodity prices are set on marginal supply cost and market demand at that price. Price takers have no control on price, but still face demand destruction and search for alternative risk. This might be a tougher cycle for consumers, but that doesn’t necessarily mean it’s better for producers.
Smaller 3Q EPS positive revisions, pre-season reporters beat by much less
The strong earnings momentum since 3Q20 shows signs of slowing in 3Q21. In the past four quarters (3Q21-2Q21), bottom-up S&P EPS was raised by 5% on average during the quarter; 1Q21 and 2Q21 had even stronger up revisions by 5.8% and 7.4% respectively. However, 3Q21 bottom-up EPS was raised only 3% during the full quarter as it was actually cut in September. In the past four quarters, pre-season reporters (August quarter end firms) delivered very strong beats of 30%+. For 3Q21, the 19 pre-season reporters beat analyst EPS estimates by only 3.6% in aggregate. We think S&P 500 companies will beat by 5% in aggregate and 3Q EPS will finish at roughly $53. Stronger beats at digital companies, Health Care and Financials, while the rest lower than 5%.
The two strong engines to this equity bull market start to down throttle
Strong EPS growth momentum and very low long term interest rates have been two bull market rocket engines. In recent months, however, there are signs that both engines are starting to throttle down. The U.S. Federal Reserve (Fed) is planning policy normalization, first tapering then rate hikes, perhaps faster as inflation persists above the Fed’s target. Thus upward long-term interest rates. Our view is that 10yr Treasury yields rise to about 2% in year and 10yr treasury inflation-protected securities (TIPS) yield approach but don’t exceed 0%. Beyond interest rates, S&P EPS growth is past its recession recovery bounce and supplemental digital surge from the new work and living modes since the pandemic. Digital service demand growth might slow, but such demand growth remains strong and is being met by digital providers at prices of consumer value as growth brings shared economies of scale. Whereas the physical side of the economy is supply side constrained. Goods demand still appears quite strong, but some orders might be customers holding place in two or more lines for one item. Material and labor constraints with a corporate tax hike could stop the ascent in quarterly S&P EPS well into next year.