2021: Tug of War Between Rising Earnings and Rising Interest Rates

The S&P 500 stock index has risen 75% since bottoming in March of 2020. It is the strongest bull market rally since the 1930s. Fueled by massive monetary and fiscal stimulus, parts of the economy have rebounded sharply. Analysts have long looked past 2020’s dismal earnings and anticipated strong growth in 2021. After nearly all of the S&P 1500 companies have reported fourth quarter results, those expectations have risen with the consensus earnings for the year now indicating 23% growth.

As vaccinations and natural herd immunity have increased, the number of new Covid cases, new positive tests and current hospitalizations are all down significantly from their respective peaks in January. The weekend approval of a third vaccine from Johnson & Johnson should further improve those trends.

As the economy gains strength and shuttered industries like theaters, restaurants, travel companies, and energy companies begin to re-open, analysts are now beginning to worry about inflationary pressures building. Indeed, the strong monetary growth and the sudden rotation of the economy from consuming services to manufactured goods is resulting in shortages and inflation which is being passed on. Supply chain disruption has stemmed from raw material and transportation shortages, both domestically and internationally. The Federal Reserve has consistently said it is not concerned about rising inflation and would in fact welcome it for a time, but fear of inflation caused longer term interest rates to climb in the past several weeks. Rising rates directly lower bond prices and hurt stock valuations.

Twenty times in the last 60 years, earnings have risen by 20% or more. Stocks fell during 9 of those years and rose 11 times. Earnings growth alone does not necessarily produce positive stock returns. Valuation matters, and nothing impacts valuation more than changes in rates. Earnings and interest rates may both rise over the next twelve months. One is a headwind for stocks; the other a tailwind. How those crosscurrents play out will determine whether 2021 is a good year for stocks once again, or not.

The LVM Team