Two “Data” items today:
#1: What can Q3 corporate earnings tell us about how structural earnings power has improved since pre-pandemic and where might markets be underestimating future improvements? In the next few weeks, we’ll see hundreds of headlines showing Company ABC posted some amazing earnings growth rate as compared to Q3 2020. Given how weak the US/global economy was a year ago, however, that’s not a useful comparison. What really matters, in our view, is how Q3 2021 stacks up against Q3 2019, when the US economy was last running full tilt.
Using data from S&P, here is how that analysis looks for the S&P 500 as a whole as well as its 11 sectors:
Overall S&P 500 earnings will be 21 – 36 percent higher in Q3 2021 than in Q3 2019:
- The S&P should earn $48.20/share in Q2 2021 based on current estimates. Actual Q3 2019 earnings were $39.81/share. That makes the 2-year earnings growth rate 21 percent.
- As we described in last night’s report, we think the market is looking for $54/share for Q3 2021, a slight but still important improvement over Q2’s $52/share. Should companies meet this estimate, that would make for 36 percent higher earnings power than Q3 2019.
The sharp-eyed reader will immediately spot a problem because the S&P 500 is up 45 percent over the last 2 years. Even if we get 36 percent earnings growth in Q3 2021 versus Q3 2019, that still leaves US large caps looking overvalued.
There is, however, another layer to this analysis; how earnings power has developed by sector:
- In the last 2 years, the S&P 500 Tech sector has increased its earnings power by 55 percent. Most of this gain, of course, came in the last 12 months (46 percent).
Moreover, since that 55 percent is based on analysts’ Q3 2021 estimates, once companies report their actual results the comp will likely be even higher.
- Large cap Health Care’s earnings power is up 56 percent over the last 2 years, again based on analysts’ conservative estimates for Q3 2021.
- Communication Services, which includes Google and Facebook, should post 45 percent higher earnings in Q3 2021 than Q3 2019. Worth noting: GOOG is expected to report Q3 2021 earnings that are 131 percent higher (not a typo) than Q3 2019, and Facebook’s comp should come in at +50 percent.
- Other sectors expected to show better Q3 2021 earnings than Q3 2019: Consumer Staples (+13 pct), Energy (+25 pct), and Materials (+103 pct).
- Sectors expected to show lower earnings in Q3 2021 than Q3 2019: Consumer Discretionary (-11 pct), Financials (-4 pct), Industrials (-11 pct), and Real Estate (-23 pct). Utilities should be flat to Q3 2019.
It is this step-function increase in earnings power for Health Care, Tech, Google and Comm Services that is responsible for the rest of the S&P 500’s return since Q3 2019. All three have seen their valuations increase over the last 2 years as markets reward their dramatic improvements in sustainable corporate earnings.
Takeaway: In terms of how to use this paradigm to make money going forward, we still believe Energy, Financials and Industrials are worthwhile trades to consider. This has been an unusual “cycle” because Tech and Health Care so dramatically reset their earnings power over a brief period. Market attention gravitated to those groups as a result. But Energy, which remains our best idea, should be able to replicate its +$40/share large cap company earnings power in the next few years and yet the estimates for the group remain well below $40/share. It is hard to identify any other S&P sector with that much of a gap between “old” and “new” earnings power.
#2: How will spiking natural gas prices affect US inflation measures like the Consumer Price Index? Spot natural gas prices in America have more than doubled this year ($2.54 to $5.40 MMBtu), and while that’s “better” than the wild price swings we’re seeing in Europe and Asia it is still a dramatic move.
A few facts to set the stage:
- “Utility Gas Service” is 0.74 percent of headline US CPI. Because it is part of the “Energy” category, it is not included in core CPI. Its weighting has been fairly constant over the last decade (September 2011: 0.87 pct, September 2016: 0.76 pct).
- The latest CPI report (August 2021) showed utility gas prices up 21.1 percent year over year. It was one of the only categories to show +10 pct annual inflation, with oil-based commodities and used cars being the others.
- Natural gas inflation was responsible for 0.2 points of headline inflation last month, so without its effect Consumer Price Index inflation would have been 5.1 percent in August 2021 rather than the reported 5.3 percent.
Now, here is a long-term (back to 1970) look at the Utility Gas Service component of the CPI on a year-over-year percent price change basis:
As you can see, natural gas-based consumer inflation has gone from high (1973 – 1983) to low (1984 – 2000), to wildly volatile (2001 – present). So, what happens if we get the sorts of price swings in 2021 – 2022 that occurred in 2000?
- If Utility Gas Inflation goes back to the all-time record of +58 percent in January 2008, that would add 0.4 points to headline CPI (58 times the 0.74 pct weighting noted above).
- That is double the most recent impact of 0.2 points in August, also noted above.
Takeaway: while the math here shows that natural gas prices have a limited effect on CPI measurements, this is one of those often purchased and essential items like food that fundamentally informs consumer inflation expectations. You need only glance back to the chart above to see the correlation between Utility Gas Services and 1970s structural inflation. The silver lining in the data is that if natural gas prices come down relatively quickly (i.e., in 2022), then inflation expectations are much less likely to reset higher.