“Market Outlook. Q2 2021” with a screen of stock tickers in the background

It’s hard to believe we already have one quarter of 2021 under our belts.

Three months flew by, but investors should be feeling good. The S&P 500 jumped 5.8%, better than the long-term average increase of 2.1%.

It feels like the wind is at our back as we start the second quarter. The vaccine rollout is gaining steam, the system is flush with stimulus and money is still cheap to borrow given historically low interest rates. Spring brings new life in the form of feeling more confident in returning to pre-pandemic life. It all adds up to growth rebounding sharply in the second quarter.

Graph titled “Impressive Growth Expected in 2021” shows quarterly change in gross domestic product (GDP) since 2015. All quarters sit between 0 and 10% until 2020. 2020 sees a drop to about -30% in the second quarter, followed by a rise to about 30% in the third quarter and back to about 5% in the fourth quarter. 2021 GDP is projected to stay between 0 and 10% all four quarters.

Sounds like a positive environment for the stock market. But is it too good to be true? The market has come a long way in a short period of time: up more than 80% since the depths of last March! And while growth could be impressive in the second quarter, that is already expected by most investors. We’re not sure how much better things can get. There are high hurdles ahead that could give investors reason to pause and the market to potentially stagnate in the second quarter.

We still believe 2021 will be a strong year for earnings and economic growth and the stock market will reflect that when the year comes to a close.

But stocks don’t move in a straight line.

Earnings Upside?

Earnings estimates continue to show a positive but unusual trend: moving higher. As the number of people receiving COVID vaccines increases, more businesses reopen and stimulus is spent, expectations for corporate profits are increasing. It’s a trend that’s been in place for the past three quarters.

In fact, the upward move accelerated in the first quarter. The S&P 500 earnings per share (EPS) growth estimate of 15.3% is now 6 percentage points higher than it was at the start of the year, based on S&P Capital IQ data. In the prior two quarters, the average increase in expected EPS growth was about 3.6 percentage points before companies started announcing results. The first quarter reporting period is set to kick off on April 14.

Earnings expectations have only moved higher two other times in the last decade: in 2018 when tax policy changed, and in 2010 when the market was still recovering from the Great Financial Crisis.

2021 feels the most similar to 2018. Many of the characteristics that shaped the move higher in earnings estimates then are still in place today. Stimulus and the speed at which it was deployed were important in both cases. In 2018, stimulus came in the form of corporate and individual tax cuts worth $206 billion. Stocks ran up more than 10% in the six months ahead of the new tax rules being signed into law. Earnings were slower to move higher, only adjusting after the law was passed. Despite that, over the next six months, the S&P 500 fell as much as 10%. The market had already anticipated the higher earnings.

Unlike in 2018, the market’s move higher has coincided with earnings expectations increasing. First and second quarter earnings estimates are substantially higher than they were at the start of 2021, making it more difficult for profits and corporate outlooks to surprise significantly to the upside. Typically, earnings growth ends up being about 4.5 percentage points better than the expectations at the start of earnings season. More recently, investors have gotten accustomed to results that are more than 10 percentage points better than initially expected. If companies aren’t able to deliver those types of beats this quarter, that could be trouble for their stocks and potentially for the market.

Graph titled “Big Surprises in Recent Earnings” depicts actual year-over-year growth relative to estimates for each quarter since 2015. The average earnings surprise is 5.3 percentage points. Major outliers all fall in 2020 with first quarter growth near 0 and quarters two through three at about 13 percentage points.

Economic Acceleration

Just like earnings, the economic recovery is expected to continue to improve over the next few months. Stimulus spending could help with more trips to restaurants and travel plans likely to be booked. All that excitement has some thinking that a year’s worth of pent-up demand could be squeezed into a few months. The Atlanta Fed’s GDPNow model currently estimates 6% growth in the first quarter, up from  4.3% growth in the fourth quarter of 2020.

The consumer could be the main driver for the growth as they shift their spending from goods to services. Millions of Americans have received two direct stimulus checks since the first of the year and that money has begun to show up in economic and other data. In March, consumer confidence showed the largest monthly jump in nearly 18 years and services’ business activity posted a record high.

Americans are also returning to work. The U.S. economy added 916,000 jobs in March and another 347,000 people re-entered the workforce. That’s amazing progress, but there are still 8 million jobs that have not returned since the pandemic began and another 4 million people who’ve dropped out of the workforce altogether. There is still more work to do.

Another side effect of the economic recovery we’ve experienced since last summer is rising inflation expectations. Some inflation is a healthy sign, but higher prices can ultimately hurt both company earnings and how far your paycheck can stretch each month.

Inflation has been increasing at the business level, as seen in the Producer Price Index (PPI) and other monthly economic surveys. While many companies have said that they’re trying to pass along higher costs to customers, we’ve yet to see a meaningful increase in the consumer inflation measures.

We are encouraged by the resiliency of the consumer and the economy. We wouldn’t be surprised to see an acceleration in economic activity over the next several months, but the uncertainty of inflation looms.

The Fed and Inflation

Stocks are trading near record levels and the U.S. economy is emerging from the COVID-19 pandemic on solid ground. In a major way that’s thanks to the Federal Reserve’s (Fed) swift decision to cut interest rates and buy bonds early last year.

Now that the recovery is underway, it’s also the Fed’s job to try and keep inflation in check. The Fed’s preferred measure of consumer inflation is the Personal Consumption Expenditures (PCE) price index. The Fed has said it’ll consider raising interest rates when “core” growth reaches 2% or more (core excludes food and gasoline prices) on a consistent basis. Higher interest rates can help temper prices.

The Fed’s current target is for this index to reach 2.2% growth by the end of 2021. But Chair Jerome Powell has pledged to keep short-term interest rates at below zero to support a full recovery of the labor market. A full recovery would require several more job reports like the March report, and the Fed isn’t projecting they will raise rates until the end of 2023.

Graph titled “Inflation Expectations Reach New Highs” depicts the 5-year breakeven rate since 2011. Breakeven rates are the difference between nominal Treasury yields and Treasury Inflation Protected Securities (TIPS) yields of the same maturity. They show the market’s implied inflation expectations over a set number of years. The breakeven rate since 2011 has been between 1.0% and 2.5% with a drop to almost 0% in early 2020, followed by a rise to over 2.5% between then and early 2021.

However, if the jobs recovery gains steam and/or inflation pressures continue to rise, we believe the risk is that Powell & co. will be pressured to start hiking rates sooner than currently expected. As we saw in 2018, that could be a risk to stocks (especially high-growth technology names).

Sectors

Sector performance in the first quarter mirrored that of the second half of last year, just as we thought it might. Financials and industrials continued to lead, and energy replaced materials as one of the top three leaders. It’s no surprise given their cyclical characteristics that these four sectors are also driving the earnings recovery in 2021. But expectations are rising for these highflyers. First quarter EPS estimates have moved highest for them, and their stock prices are rising even faster.

We still think these sectors will do well as the year progresses, but in the near-term, many of them have gotten a bit expensive. Defensive sectors, including consumer staples and healthcare, have caught our eye given their underperformance and more reasonable valuations. Plus, as the market debates where inflation and interest rates will go from here, volatility could return. Having some defensive investments in your portfolio could help ease your mind if a storm were to brew.

Overall, we still think growth sectors are likely to take a back seat this year, especially as interest rates rise. As we usually say, a diversified portfolio is the best way to prepare for the remainder of the year.

The Bottom Line

The market may be ready to take a breather as investors digest all the good news, determine how much of that is priced in and weigh it against uncertain risks like inflation.

To be sure, the backdrop in 2021 suggests there should be more room to run, but right now the market is expensive. The S&P 500’s price-to-earnings ratio (P/E) is 23x. Combining that with a high bar for earnings and a seasonally weak summer period, investors could take a wait-and-see approach near-term.

Callie Cox, Senior Investment Strategist, contributed to this article.


 
Speech bubble icon next to text "Expert Take"

Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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