04.26.2022: Equity markets have been having trouble digesting the prospect of higher interest rates as they come off a decade in which valuation expansion was the primary force behind robust equity market returns. Between 2011 and 2021, the S&P 500 grew by a whopping 362 percentage points, about 16.5 per cent annualized. Of that super-sized return, 254 percentage points was derived from valuation expansion – investors’ willingness to pay increasingly more for a dollar of earnings. That left just over 100 percentage points, about 7.6 per cent annualized growth, deriving from earnings and dividends over that period. Continually lower interest rates relative to inflation were largely behind the valuation expansion. By the end of last year, the overnight rate was nearly seven percentage points below the inflation rate, a record. As the tailwind of valuation expansion recedes, we believe earnings and dividends will be forced to resume a vital role in equity market returns over the next 10 years.
Nearly half the market capitalization of the S&P 500 is set to report earnings this week, including Microsoft, Apple, Alphabet and Amazon. Investors are keeping their fingers crossed, hoping that Q1/22 earnings will buoy an equity market buffeted by the prospect of tighter financial conditions. S&P 500 EPS and revenue growth are both on track to top 1Q expectations after the first 100 companies reported, but mixed margin results, particularly from the big banks, may be weighing on market sentiment. So far, about 100 companies have reported with just over two-thirds of them beating analysts’ revenue expectations, thanks largely to strong demand and higher prices. That was appreciably better than the 59 per cent median forecast. About three-quarters of reporting companies beat on the bottom line, but that number is in line with its longer-term median result, as companies are having a harder time maintaining their target profit margin.
S&P 500 earnings growth is tracking at 6.9 per cent, which is slightly better than the 5.2 per cent consensus expectation going into earnings season. Nonetheless, earnings growth has been in steady decline since its peak in Q2/21, thanks in large part to pandemic-level comparisons. Using Q1/21 comparisons has slowly removed the exaggerated “base effect” from global lockdowns and will normalize earnings growth later this year.
Investors have clearly pulled in their horns this year in the face of a bombastic Fed. Dividend stocks have managed to remain in positive territory, gaining about 6.5 per cent so far this year, while growth stocks, after surging 32 per cent last year, have given back more than 17 per cent. Growth stocks had been the biggest beneficiaries of valuation expansion. Value stocks, meanwhile, relying on their earnings power and dividend yields, are only off about two per cent for the year. While high-quality companies fared better than growth stocks, they’re still off more than 10 per cent in 2022.
We believe high-quality companies are well positioned to weather tighter financial conditions as the Fed and lenders tighten the screws on credit. Quality companies already enjoy premier borrowing rates, so their incremental funding costs will remain relatively cheap as nominal rates climb. Their lower-quality brethren would be relatively disadvantaged. High-quality companies are currently enjoying a significantly higher profit margin, at 17 per cent, vs 12.8 per cent for the S&P 500 overall. That’s beneficial, as companies could potentially get squeezed between higher costs and raising prices. Moreover, many of the highest-quality companies not only pay a healthy dividend but have the wherewithal to pay out consistent and expanding dividends over time. That’s particularly useful to investors hoping to maintain investment income that stays ahead of inflation. History has shown that high-quality, dividend-paying companies indeed deliver income streams that enable their holders to stay ahead of inflation. That’s something that not even high-quality bonds can offer.