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Why earnings growth is complicated right now

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Lori Calvasina, RBC Capital Markets head of U.S. equity strategy, joins Yahoo Finance to discuss the outlook on the market and economy.

Video Transcript

JULIE HYMAN: Let's turn now to the broader market and what we could expect this year. This event not withstanding, we're still seeing a lot of high expectations for growth this year in the United States, and perhaps earnings growth as a result. So let's talk about that with Lori Calvasina. She is RBC Capital Markets Head of US Equity Strategy.

Lori, it's great to see you. So you guys just raised your outlook for earnings per share this year for the S&P 500, 177 for 2021 and 193 for 2022. And this is basically a reflection of economic growth forecast, right. Where do you think the real engines--


JULIE HYMAN: --are going to come from here when we're looking at this earnings growth?

LORI CALVASINA: Sure. It's a great question. And let me just first say I think earnings are very, very complicated right now. We felt like our GDP assumptions were too low. Our economist raised his number to 6.6% for this year, 4% for next year. We'd been basically baking in 5 percent-ish and 3 percent-ish previously, so we wanted to recognize that the economic backdrop was a bit stronger than what we'd been baking in.

And generally, you know, that was really the bulk of the upgrade there. Also, last year's numbers came in a tad bit higher than what we'd anticipated. I will tell you, Julie, you know, listening to the margin discussion-- or the inflation discussion you guys just had, you know, that's something that definitely informed our thinking on margins.

And if it weren't for that inflation issue, I would say that our margin assumptions where we've got a partial recovery back to 2019 levels baked in might be too conservative. But we were reluctant to pull up the margin expectation right now with all these inflation pressures looming. Nevertheless, despite that complicating factor, we thought it was prudent to bump our number up a bit.

BRIAN SOZZI: Lori, within the context of looking at the first quarter and even-- even the second quarter, the Suez issue, is that a big potential earnings headwind for the S&P 500?

LORI CALVASINA: It might be. I mean, I think that the-- we're, frankly, just going to have to really take our cues from these early reporters and see what they say. And I think it's helpful that some of the companies are already starting to talk about it a little bit. But I do think that this is also going to be sort of a point in time where the GDP backdrop should be pretty strong. And so we should-- we're seeing the vaccinations ramp up very quickly. We're seeing, frankly, this market is getting surprised at how quickly some of the economic activity is coming back.

So that should help offset that. It's going to be messy, but it could have some short-term ramifications. I think, though, you're spot-on. Investors may give companies a pass on that. What I think they're going to care about more are the longer-term inflationary pressures.

JULIE HYMAN: Let's talk a little bit more about those because, as you said, margins is really where this thing can turn, right.


JULIE HYMAN: And-- and as you said in your note, it presents both upside and downside--


JULIE HYMAN: --and you don't entirely know where it's going to go at this point. One of the things you mentioned besides this inflation on goods is possible unit labor costs, which we have not--


JULIE HYMAN: --seen yet that much.


JULIE HYMAN: Where are you looking for signs?

LORI CALVASINA: Well, I think that's a great point, Julie. And you know, one of the things we do on my team is this very painful exercise of reading through all the S&P 500 earnings call transcripts. I have a lovely woman on my team named April who spearheads this project for me. And you know, what's-- what she really impressed upon me is that we are not hearing nearly as much about labor costs in the margin discussions as we've heard in past quarters.

We are hearing, though, a lot about structural efficiencies that were gained during the pandemic. In other words, these management teams are super smart, and they really figured out ways to cut costs. And that is going to flow through to the margin line as we see revenues improve. But labor costs are huge. We heard a lot of chatter in the past. And it's a little weird that we haven't heard about it recently. Certain sectors, yes, but generally, no.

BRIAN SOZZI: All right, Lori, you're bringing me into your margin optimism. What's the-- what's the best-case scenario for your team for the S&P 500 this year? How good could it get?

LORI CALVASINA: So our target is 4,100. And you know, we're very quanti in terms of how we pull that data together. We have 15 different upside scenarios, and that's really the median of the different scenarios. We do bring in our technical strategists to give us some color.

We have also baked in some-- some very robust, you know, sort of quantitative measures on our own. The highest number we've come up with in a couple of scenarios is a high 4,500, so you can round it and say 4,600. That would be my bull case. It's not my base case, by any stretch.

We do not feel the urge to jerk that target up at this point in time, given with what we see in terms of really extended valuations from a bottom-up perspective, very peakish sentiment indicators on our works. We feel like this is the wrong time to upgrade. But we have been very open with people and said if we're wrong on the 4,100 and too conservative, that's kind of the upper end of where we could see this thing going.

JULIE HYMAN: Lori, what-- what role does tech play in that upside scenario, right, because there's been a lot of chatter that you can't see huge growth in the major averages without tech participation?


JULIE HYMAN: Lately, we haven't been getting it, at least not-- certainly not to the same degree, obviously.

LORI CALVASINA: It's a great point, Julie. And we frankly view that as an anchor on the S&P 500. It really depends-- we know that the math is against the S&P of tech experience as a drawdown. We've got a fantastic chart in our latest monthly where we look at how the market cap exposure in TIMT in the S&P 500 far exceeds what you see in cyclicals.

And that's a reversal from the historical relationship. We did usually see, in the past, the S&P was more cyclical. That's just not the case anymore. The issue, and I think the thing that that's sort of tough to model, is how much rotation you get and how much does that rotation help lift the S&P.

You know, we've done some scenario analysis at the beginning of the year where we said if tech falls 5%, 10%, 20%, how much would the S&P fall, and it's not a pretty picture. But I will tell you that in the drawdown that we just experienced in technology, we actually saw that the rotation into other areas like financials, energy, materials was actually greater than what we had been modeling at the beginning of the year.

One of the things also that happened was that the communications services sector ended up being a bit more resilient and actually did decently well. People started to view it as a cyclical area of the market that could benefit from the reflation tailwinds. So I think that tech, generally we know it needs to calm down before this market can really break out higher, but I don't think you can write off the year yet just because there might be further drag on technology.

JULIE HYMAN: Gotcha. Interesting. And one other point you bring up in your note that I think is interesting, as well, is that you like small caps here.


JULIE HYMAN: And this is a group that's already done pretty well year-to-date. People are getting into it. And it does tend to be-- you know, the sort of conventional wisdom is it tends to be more economically sensitive, right, the small caps. So is--


JULIE HYMAN: --that what's going on here, as we see this expansion so, too, go the small caps?

LORI CALVASINA: I think so. I mean, I mentioned that relationship of the S&P 500 being more TIMT exposed. Well, small cap is still much more cyclically exposed than exposed to secular growth. And so it should function as a pure play on the domestic economy, and that is exactly how it's trading right now. It tends to actually outperform large caps when inflation expectations are rising. It also tends to outperform when the yield curve is steepening.

The ISM relationship is another positive one that we see for small caps. So it is acting the way that it should based on its market cap representation. I think have to keep your eye on the big picture here. We are going to have some days when this recovery is in doubt. We are going to have some days when people take profits on this reflation trade, and small cap won't do well on those days.

But we think we are very early in this economic expansion, and the valuation runway is still there. The valuation problem is far greater in the S&P than the small caps. Relative multiples between small and large are still near historic lows and have a lot of room to catch up.

BRIAN SOZZI: And Lori, you have a neutral stance on US stocks versus non-US stocks. Why is that?

LORI CALVASINA: Yeah, you know, it's interesting. I'm not a global strategist, so I don't want to try to sit here and pretend I'm anything that I'm not. But we do try to put the US call into a global context. And at the beginning of the year, we made the observation that everything was really just sort of lining up for this rotation out of US into non-US equities.

And we saw that in terms of valuation where US looked overvalued. We saw that in terms of positioning and sentiment where US looked over-owned. And depending on what indicator you looked at, it was either Europe, Japan, emerging markets looked under-owned. Those conditions all still exist, so we don't want to totally tell people to veer back into US stocks.

But the thing that has changed is that the virus backdrop is simply better in the US than Europe right now. We see that in terms of the case trends. We have also seen that flow through to economic expectations. At the beginning of the year, the GDP recovery was expected to be stronger in Europe than the US.

We have seen European GDP forecasts come down, US GDP forecasts continue to rise, and now the US is back on top. So the economic backdrop is the thing that has changed because the virus backdrop has changed. So we think you want to just basically be neutral. Those old problems haven't gone away, but the economic dynamic has changed.

JULIE HYMAN: Lori Calvasina, RBC Head of US Equity Strategy. Thanks for giving us some insight into your process there. Poor April on your team reading through all those-- all those-- but it's important work, obviously. You get really good insight--


JULIE HYMAN: --from doing that kind of really deep digging. Thanks so much, Lori. Appreciate it.

LORI CALVASINA: All right. Thanks, Julie. Thanks, Brian.