“This week the S&P 500 rallied above our year-end 2020 target of 3,000”, Goldman’s David Kostin writes, in a note dated Friday evening.
“The current index level implies an optimistic path of normalization”, he adds, somewhat dryly.
It sure does. The benchmark has risen 3% or more in three of the last four weeks, despite a laundry list of concerns, not least of which are spiraling Sino-US tensions, still dour data, the prospect of a second virus wave and, now, a wave of protests against racial injustice in the US. But liquidity-driven markets are difficult beasts to tame.
Goldman goes on to flag the pro-cyclical rotation which played out to dramatic effect on a couple of days this week, on the way to reiterating their year-end S&P target of 3,000. In other words, the bank does not see US equities higher by the end of the year.
“A blend of monetary and fiscal policy initiatives, a bending of the viral curve in the US and optimism around the economic restart have buoyed the market to this point [but] the path of the S&P 500 through year-end is not likely to be smooth”, Kostin writes, adding that “uncertainty around virus developments and the pace of re-hiring could present fundamental challenges while escalating rhetoric around US/China trade and the 2020 election that is less than six months away present policy risks”.
The bank then flags a dramatic plunge in return on equity attributable to the largest drop in margins in 50 years.
“The 150 bp drop in margins from 15.5% in 4Q 2019 to 14.0% in 1Q 2020 was the largest quarterly decline since 1970 and accounted for 214 bp of the 196 bp decline in ROE”, the bank says, noting that “record high leverage, lower interest expense, and the lowest effective S&P 500 tax rate of the last 50 years did little to offset the weight of lower margins”.
Goldman writes that trailing 12-month ROE rose in just three of 11 sectors in the first quarter. “Looking ahead, S&P 500 profitability will decline further in 2020”, Kostin cautions. He does say things should improve in 2021, though.
Not surprisingly, the bank’s outlook for a rebound next year hinges at least in part on tech. Goldman sees net profit margins falling by 200bps this year to 8.7%, and they note that this is a somewhat vociferous debate among investors.
“Some argue that lower interest rates and wage costs should boost profitability and others [say] that health safety costs, supply chain restructuring, and ongoing revenue headwinds should weigh on profit margins even as the economy recovers”, Kostin writes, on the way to saying that Goldman’s forecast for a 2021 bounce-back is partially predicated on “the above average market power of large-cap firms as well as the index’s concentration in the high-margin, fast-growing Info Tech sector”.
Kostin touches on leverage, and that naturally means flagging the massive wave of investment grade issuance, which topped $1 trillion YTD last week, 70% above the five-year average run rate.
“The median S&P 500 firm’s net debt to EBITDA ratio of 2.1x is the highest in at least the last 40 years [but] despite rising leverage, falling interest rates have lowered aggregate S&P 500 interest expense”, he notes. Goldman expects the Fed to remain accommodative for the foreseeable future, which means the cost of servicing the higher debt burden shouldn’t become crippling and therefore won’t threaten return on equity – or at least not in the near-term.
However, uncertainty around tax policy is now of some concern, just ask Gary Cohn, who last week told CNN that the next Congress “need[s] to look at our tax system and think of ways we raise revenue” in light of higher spending, ironic coming from the architect of Trump’s tax cuts.
“The 2020 election is just five months away, and prediction markets now price a 79%, 51%, and 52% likelihood of Democratic victories in the House, Senate, and presidential races, respectively”, Kostin writes. That’s right folks, betting markets now see the GOP losing it all.
In that scenario, Goldman sees at least a partial rollback of the Trump tax cuts, and perhaps a full reversal, which mechanically would cut the bank’s 2021 EPS forecast for the S&P by $20.
If you’re wondering how expensive the index is at current levels versus the historical relationship between ROE and price/book, the answer is about 16%. “Fair” would be somewhere down around 2,550.
However, Goldman says investors are looking through this year given the rather anomalous circumstances, focusing on 2021 instead. On that score, the bank writes that “the S&P 500’s current valuation appears broadly consistent with the historical relationship between consensus FY2 ROE and P/B”.
As ever, you can draw your own conclusions, but without delving into the specifics, allow me to sate the obvious about the social unrest sweeping across America this week.
When it comes to resurrecting the US economic machine (depending as it does on consumer spending), violent protests in some of the country’s largest metropolitan areas do not bode particularly well, especially if they end up serving as conduits for new virus outbreaks.
Hopefully, cooler heads (and justice) will prevail.