The virus and the vaccine
Despite investor focus on the prospective policy implications of the Biden presidency, the vaccine for COVID-19 is a more important determinant of the path of both the economy and stock market in 2021. The positive preliminary phase 3 trial results from PFE revealed that its COVID-19 vaccine exhibited an efficacy rate greater than 90%, well above what many medical experts had anticipated. However, the timing was consistent with the expectation by Goldman Sachs Biotechnology and Pharmaceutical equity analysts that a vaccine would be identified before year-end. We expect the PFE vaccine, and perhaps other vaccine candidates, will receive emergency use authorization (EUA) by January, and sufficient doses will be available to vaccinate the US population during the first-half of 2021.
We lift our S&P 500 EPS growth estimates to $136 in 2020 (-17%), $175 in 2021 (+29%), $195 in 2022 (+12%), $207 in 2023 (+6%), and $218 in 2024 (+5%). Our revised growth estimates are roughly in line with our previous estimates, but the level of 2024 EPS is $4 or 2% higher to reflect the increased starting point of 2020 profits. Our increased estimates primarily reflect much better-than-expected results in 3Q. S&P 500 EPS in 3Q 2020 was expected to fall by 21% but realized growth of just -8% (+$5 swing).
Bottom-up analyst revision sentiment is now extremely positive and we expect consensus estimates will have additional upward revisions. Our 2021 top-down EPS forecast is 4% above the consensus bottom-up estimate of $168 and 13% above the median consensus top-down estimate of $155.
Outside of economic activity, a weakening USD and slack in the labor market should support S&P 500 sales and margins, respectively. The US unemployment rate registered 6.9% in October, well above the estimated natural rate of unemployment (4.4%). Our top-down model demonstrates that a loose labor market is typically positive for earnings growth, as wage growth exerts limited pressure on margin growth. Our FX strategists expect the trade-weighted US Dollar is in a structural downtrend, which typically acts as a tailwind to S&P 500 revenues, particularly for international-facing sectors. Their FX estimates assume the USD weakens by 5% vs. the Yen (to 100) and by 6% vs. the Euro (to 1.25).
The S&P 500 index levels we forecast imply a modest P/E multiple expansion next year. The market currently trades at 20.3x our top-down 2021 EPS estimate. Our DDM-derived price target implies that during 2021 the forward P/E multiple will expand by 2x to 22.1x. The implied absolute valuation at year-end 2021 would rank at the 94th percentile vs. history.
However, our year-end 2021 forecast for valuations relative to bond yields would rank in just the 51st percentile vs. history. Accommodative Fed policy and low interest rates make equities appear attractive on a relative basis vs. fixed income alternatives, pushing investors out on the risk curve. With the earnings yield gap of 323 bp above the projected year-end 2021 Treasury, our price target implies a relative valuation roughly in line with the long-term average, less extreme than signals from absolute valuation metrics (see Exhibit 12).
The backdrop of low interest rates and subdued policy uncertainty that we anticipate during the next two years will be constructive for equity valuations. Our valuation framework relies on the cost of equity, which in turn depends on interest rates and the equity risk premium. The key drivers of our ERP model include breakeven inflation, policy uncertainty, consumer confidence, and change in the size of the Fed’s balance sheet.
Interest rates: We assume stable Fed policy and limited yield curve steepening. Given the Fed’s new average inflation targeting (AIT) framework and its forward guidance for the funds rate, Goldman Sachs Economics forecasts the first hike in the funds rate will not occur until 2025. We assume higher breakeven inflation will drive modest yield curve steepening as the ten-year US Treasury yield climbs from 95 bp today to 1.3% at year-end 2021 and 1.7% by the end of 2022. Diminished prospects of massive fiscal spending that might have occurred under a Democratic sweep coupled with extremely low bond yields globally will limit the rise in nominal US yields.
Equity risk premium: Improving growth expectations and falling uncertainty will compress the ERP. Our economists’ baseline forecast for fiscal stimulus and vaccine approval should drive an improvement in growth expectations, breakeven inflation, and consumer confidence, in turn pushing the ERP lower. The economic policy uncertainty index has averaged 227 during the last year, 100% above the long-term average, and has kept the ERP elevated (Exhibit 9). However, we expect a divided government will reduce uncertainty sharply by year-end 2022 (to 125, in line with the long-term average).
My that equity risk premium is a handy lever to pull. It can justify anything. Check out especially the permanently high plateau of massive multiples in exhibit 11.
It’s never happened before but there’s always a first time, I guess. I do not expect any inflation so that ERP can go on forever!