Corporate profits have been one of the few bright spots in a thoroughly miserable year. Company earnings recovered strongly during 2021 and, in most cases, have now more than regained all the ground lost after the Covid pandemic originally emerged.

The strength of this revival in profits has been, without exaggeration, truly spectacular. Rebounding earnings proved that even the most optimistic projections from analysts were, in fact, too pessimistic.

In the end, companies delivered earnings results that beat analysts’ projections during every one of the last six quarters — a consistent pattern of expectations being exceeded. In addition, higher revenues represented a welcome surprise following a long period of weak growth.

Earnings per share (EPS) in 2021 were surprising in terms of both their breadth and magnitude (i.e., the degree to which results exceed projections). This year, on average, more than 80% of the companies that comprise the S&P 500 Index managed to beat analysts’ profit projections, with many doing so by double-digit percentages (Chart 1).
Chart 1: S&P 500 quarterly EPS surprise vs expectations
This is highly unusual, but not necessarily unique. We saw something similar (albeit on a smaller scale) during the recovery from the global financial crisis in 2009.

Additionally, exceptionally strong cash flows have led to a resurgence in corporate buy-backs — with more than US$1 trillion being authorized this year — as well as a recovery in capital expenditure, which both suggest increased corporate confidence. Equity markets have reacted well to these reassuring earnings results, with strong performances since the pandemic-induced lows recorded in March 2020.

Permanently higher all-time highs?

Data going back to the 1930s show that, on average, it takes some 10 quarters for S&P 500 Index company profits to regain lost ground following an earnings recession (Chart 2).

The Dot-com bust, some two decades ago, required 14 quarters before previous highs were regained. Following the global financial crisis, the recovery period was even longer (at 17 quarters). In contrast, the post-pandemic recovery has been surprisingly fast and strong, with S&P 500 Index EPS returning to pre-Covid levels after only three quarters.
Chart 2: Number of quarters for S&P 500 profits to regain previous highs
In the US, corporate earnings are already some 20% above their long-term trend. This does not necessarily mean an imminent reversal, as earnings typically overshoot during a recovery. However, this usually takes several years, rather than a few quarters, into a recovery. Margins have fully recovered (and, in some cases, reached unprecedented levels), while corporate profitability is at all-time highs.

Naturally, the key question remains "where now?" Operating leverage tends to be most powerful in the early stages of economic expansion, when revenues rebound much faster than costs.

These gains have largely materialized already — capping future upside from here (Chart 3). Meanwhile, rising input costs are likely to limit margin expansion, even if revenues continue to deliver.

In addition, global initiatives to increase corporate taxation (or reduce tax avoidance) have the potential to erode multinationals' profitability. In all, margins offer little upside to profits.
Chart 3: Operating margin per region

Headwinds emerging

There has been a long run of positive surprises, despite earnings revisions running "hot" for a considerable period (i.e., analysts’ upgrades to future earnings significantly outnumbering downgrades). This will not continue forever.

One area of concern relates to increased input costs as a result of inflation. The rapid reopening of economies has pushed up demand, while residual Covid restrictions have constrained supply. This has created a perfect storm, as prices have adjusted upwards and various bottlenecks emerged — from factory utilization to port congestion.

Third-quarter corporate disclosures have seen a nine- fold increase in mentions of the word ‘inflation’ when compared to the same period in 2020. The terms "raw materials," "supply chain shortages," "labor pressure" and "transportation costs" have also featured frequently.

Inflationary pressures mean that we have likely seen most of the margin expansion in this cycle, and that future profit growth will largely be dependent on demand outlook and pricing power.

We think that a deceleration in earnings growth is inevitable and it will be a natural development as the cycle matures.

Additionally, other significant headwinds have emerged: the macro outlook is weakening considerably as a new Covid variant emerges; while policy direction in China and the developed world is generally turning less favorable.

Looking ahead

We are at an important juncture. While the first half 2021 marked the peak in profits growth, this should not be mistaken for peak profits.

The slowdown in the rate of growth has been inevitable as the recovery advances. But there are no reasons to believe that corporate profitability couldn’t continue to increase for some time. A global forecast of two years of above-trend nominal gross domestic product (GDP) growth underpins strong revenue forecasts, which should translate into robust EPS growth even if margins remain constrained.

In general, broad-based inflation and a strong nominal growth environment are supportive of corporate revenue and profits growth. Robust nominal revenue growth can offset cost increases and prevent margin compression up to a certain point. This means that earnings' future trajectory will reflect revenue growth and not benefit from margin expansion.

We can conclude that the "sweet spot" for corporate earnings is now behind us and the EPS outlook will continue to moderate. However, the outlook still remains favorable — at or above the long-term EPS growth rate, and consistent with mid to high single-digit EPS progression.

In particular, the outlook remains bright for those companies that can pass on price increases and grow their top-line revenue faster than their cost base. Companies with good pricing power that can grow their earnings in an inflationary environment should emerge as winners. Those with high margins are also in a good position as they may be less sensitive to rising input costs. Businesses with short supply chains and a good sourcing strategy are also likely to continue outperforming.

The initial early recovery from the pandemic lifted all boats, as stocks across all sectors participated in a strong profits upswing. Going forward, as the cycle matures, the opportunities to make money are likely to be more selective than before.

There are some sectors which remain well positioned for continued earnings growth. For instance, industrials are likely to benefit from a strong capex cycle as companies have increasingly committed to capital investment. Recent supply chain disruptions have likely expedited some of these capital expenditure plans.

As economies fully reopen, there is also scope for a shift from goods to services consumption, which could benefit consumer services stocks, especially in areas which have not yet fully recovered due to pandemic restrictions.

This outlook is, naturally, not without risk as visibility remains constrained due to the emergence of a new Covid variant and the uncertainties around central bank policy.