- Stocks are off to another hot start in Q3 after rising in nine of the year’s first 10 months.
- Corporate earnings have been far better than expected despite a slew of serious concerns.
- UBS sees further upside for the S&P 500 heading into 2022 – especially in four sectors.
Don’t underestimate corporate America. That’s a lesson stock market bulls – who’ve driven equities up 23% this year – have learned, even if some Wall Street analysts still haven’t.
Three-quarters of third-quarter corporate earnings reports are in the books, and as in Q1 and Q2 the results have easily topped consensus estimates despite a litany of concerns. Earnings, which are now set to rise 36% year-over-year, have topped expectations by 11%, while revenue has beaten predictions by 1% through the first month of Q3, according to UBS.
“While there have been some high-profile earnings disappointments, corporate America is actually managing reasonably well and profit margins have been better than expected,” wrote Solita Marcelli, UBS’s Americas CIO, in a November 1 note.
Earnings growth will slow from its breakneck pace to 10% in 2022, but that should still be enough to drive the S&P 500 higher, Marcelli wrote. The firm’s price target of 5,000 by the end of 2022 implies an 8% upside to a stock market that has shown few signs of losing steam.
“While growth is decelerating as comparisons get more challenging, this is still a very strong result considering the magnitude of the supply constraint-induced economic slowdown experienced during 3Q,” Marcelli wrote.
There are several risks for stocks in 2022, according to UBS. Continued supply-chain backlogs and the possibility of higher corporate taxes are the main issues, as suppliers’ inability to meet demand dampers revenue combined with higher taxes would give firms’ bottom lines a haircut.
But there’s also reason for optimism, Marcelli wrote: Asian factories that were shuttered because of the COVID-19 threat are reopening, some automakers will be able to boost vehicle production as chip shortages get resolved, and demand for goods will continue to moderate.
So far, it appears that the positives are outweighing the negatives. Just look at the S&P 500, which has posted a 7.5% gain so far in the fourth quarter (when Q3 results are shared) despite fears that supply-chain issues, shortages, and rising labor costs would harm firms’ profit margins.
“Demand remains robust and there are signs that supply chains are improving in some areas,” Marcelli wrote. “Overall, better-than-feared earnings results have propelled the S&P 500 to a new record high. Our outlook for continued solid earnings growth is a key pillar of our expectation for further equity market gains.”
Where to invest in late 2021 and into 2022
Gains for the broader market have been easy this year. The S&P 500 rose in nine of the first 10 months of the year and is off to a solid start in November.
But investors would be wise to be choosy as the year winds down. Marcelli noted that higher costs and supply-chain impairments are hurting stocks in certain industries and sectors – such as industrials, consumer discretionary, and technology hardware – more than others.
“Some companies are clearly having a harder time contending with elevated commodity, transportation, and labor costs,” Marcelli wrote. “Much of the pain is being felt in consumer and transportation segments, especially those that are labor-intensive like restaurants and freight. Not surprisingly, airlines are also having a hard time passing on higher jet fuel prices.”
It makes sense, then, that analysts have slashed earnings estimates for firms in the consumer discretionary and consumer staples sectors as well as the airline industry, Marcelli wrote.
However, Marcelli also wrote that those downward revisions have been “offset” by upward boosts to firms in the energy, financials, and materials sectors. Price increases for inputs like energy and materials benefit the companies that produce them. Financial companies profit from higher inflation, given that they’re correlated with interest rates hikes, which boost bank profitability.
UBS prefers stocks in the following sectors: consumer discretionary, energy, financials, and healthcare. Though some discretionary names will suffer from higher costs, companies with pricing power can pass on costs to consumers through higher prices, Marcelli wrote. This logic can apply to healthcare stocks, given that their services tend to be price inelastic. That means people are typically willing to pay more for health-related goods and services if necessary.
In terms of investing factors, UBS likes mid-caps over large- and small-caps while leaning toward value stocks over their growth counterparts. Mid-caps and value names both tend to be economically sensitive and beneficiaries of an improving economy.