Savita Subramanian, Head of US Equity & Quantitative Strategy at Bank of America joins Yahoo Finance Live to break down how stocks are faring amid the pandemic and outlook for economic recovery.

Video Transcript

MYLES UDLAND: Joining us now to talk about the earnings outlook and about the setup for stocks over the balance of the year, Savita Subramanian, the head of US equity and quant strategy over at Bank of America Global Research. Savita, great to have you on this morning.

Let's just start with your first impressions-- or I guess, we're in the middle of the impressions here-- from first quarter earnings and how it's kind of factored into what you guys are thinking, you know, where earnings might go this year. And I guess, a way of asking it is, how much better than the pre-crisis 2019 peak are you now thinking 2021 earnings per share might come in at?

SAVITA SUBRAMANIAN: Yeah, great question. So I mean, earnings so far is tracking really healthy. I mean, we're tracking a sizable beat at this point. I think we were forecasting a 6% beat. And we're tracking a bit higher than that 7% beat. I mean, what's interesting right now is that we haven't really seen companies react to positive news.

So I think where it's getting interesting is just the earnings reactions are actually signaling that investors are fairly overweight the stocks that are actually beating estimates. And we're not seeing that much of an alpha from beat. So right now, we're tracking less than 100 basis points of alpha when a stock actually beats on earnings and revenues. And historically, that's been closer to 2% to 3%, so I think this is a very anemic reaction.

Now in terms of full year, we are expecting 2021 to eclipse 2019. We're seeing really strong signs of an economic recovery. We've got stimulus. We've got kind of everything that lined up to make-- to set the stage for a very bullish earnings recovery. I think the one risk to that basis is inflation. And we can talk more about that. But I think what we're hearing so far is that inflation is good and that companies are able to pass on rising raw input costs and labor costs through pricing.

But if that changes for any reason, I think that's where you start to see margins compressed, and that's where things go wrong. So that's one of the factors we're watching. We're expecting to see over 30% earnings growth this year. It's going to be a blockbuster year for earnings. The problem is, the market is already pricing in that level of earnings and maybe a little bit more than that. And in our view, we may not see further strong gains from the S&P 500. But we could continue to see gains from some of the more cyclical areas of the market.

JULIE HYMAN: Savita, it's Julie here. Not only are you guys not looking for further gains from here, you're actually looking-- your year end target for the S&P is 3,800. So you're looking for a drift lower from here. What gives there?

SAVITA SUBRAMANIAN: Indeed.

JULIE HYMAN: Is that-- does that reflect some of the risks you were talking about, inflation not being able to pass on costs and margin compression? What's going on?

SAVITA SUBRAMANIAN: Absolutely. Yeah, what's going on? So I mean, absolutely. I think that the risks are inflation. And so far, so good. So that's not necessarily what's making us more cautious towards the end of the year. But I think that the news flow is going to get a little bit more negative. And we're already hearing it. We're already hearing about payback for stimulus, right?

I mean, how are we going to pay back all this money that we borrowed from the government? It's probably going to be through some kind of a hike in tax rates, which potentially hurt some of the higher end consumption. Capital gains rates are potentially going to move higher, which potentially hurts the appetite for equities of individual investors, which have been a major participator in this bull market, especially over the last 12 months. So I think that a lot of those types of factors make me a little bit nervous.

And then on the inflation front, it's not so much earnings I'm worried about, but it's more about the Fed and how the Fed is able to kind of absorb potentially higher inflation that might not be transitory. And I think that's the million dollar question-- is what we're seeing transitory and manageable, and it's going to go away because we're going from 0 to 100 on the economy? Or is it the signs of a longer, more secular, inflationary cycle coming off of massive fiscal stimulus and the lowest interest rates we've seen in, by some measures, 5,000 years? So it almost seems like the stage is set for things to get a little bit worse on the cost of capital side on the inflation side rather than better.

JULIE HYMAN: How do we know if it's transitory or not, Savita?

SAVITA SUBRAMANIAN: This is--

JULIE HYMAN: Sorry, Brian.

SAVITA SUBRAMANIAN: This is exactly right.

JULIE HYMAN: How are we going to know? How long do we have to wait?

SAVITA SUBRAMANIAN: So I think what you want to watch are a few things. And there are canaries in the S&P 500 that basically sniff out strong inflationary pressure. And we have a basket of stocks that have basically been very correlated and the leading indicators of inflation. So far, they've been moving higher in a demonstrable fashion. And these are kind of the companies you would think of as the canaries of the economy. They're machinery, they're energy, they're kind of raw materials plays.

Now, if those stocks taper off, or if you start to see a deceleration in gains, then I think that what the market is telling us is that inflation is manageable. The other thing I would look at is margins. And I would watch when we're starting to see pricing power go away from companies. And so far, we've seen demand surge. And that's been good for pricing. But if that stops or if that tapers off, I think that's another tell. And then from a longer term perspective, I think what we need to watch are some of the forces that have kept inflation low. Where are we in those cycles?

So, for example, think about disruption. And, you know, just in retail, we've seen internet take share from brick and mortar. And that's been a source of disinflationary pressure. Now, where are we in the cycle? Well, at this point, 60% of sales by our credit card data is internet, and 40% is brick and mortar. We're coming off of a very high level of online retail because all we could do was online retail. So I think that those are the barometers to watch just to think about where we are in that secular trend.

Demographics-- I don't know if demographics are necessarily going to be disinflationary. This was the mantra that we heard for the last 20 years, is that as the population ages, you know, folks spend less. And that's a suppressant on inflation. I mean, one of the other counterarguments is that as there are fewer and fewer workers, wage inflation could actually go through the roof. So I think demographics is not necessarily a slam dunk on inflation or deflation. So those are some of the barometers I would watch.

But again, I don't think the market is pricing this in. When you look at investors' positioning, when you look at valuations, we're still in an environment where a lot of the secular disinflationary beneficiaries are trading at significant premia to the inflation winners.

BRIAN SOZZI: So the opening bell on Wall Street on this Friday morning. Lots of earnings reports to digest. Charles Schwab is actually ringing that opening bell. Savita, I'm going to bring you into the battle Julie and I have been having on corporate taxes, really, over the past month. So no pressure here. You don't have to take sides, but we look at the historical data. And the data says that the markets could shake off higher taxes. Do you think that's the case here?

SAVITA SUBRAMANIAN: I think to a certain extent. I mean, I think that what you're going to see is a meaningful drop in earnings. But to your point, I mean, here's what we've found in our quant work. And this is where I'm a numbers gal. We look at all these repressions and kind of try to track relationships. There's really no strong relationship between corporate tax rates, capital gains tax rates, even individual tax rates, and market. So it's hard to make a call one way or another.

There are very strong themes from a sector perspective. So as you start to see individual income tax rates increase, especially at the wealthy, you've definitely seen discount retail outperform luxury. I mean, you've seen some of these sort of obvious trends take place. At an overall level, I think that a tax hike on corporates somewhere-- meeting somewhere in the middle between 35% and where we are now would be absorbed by companies. A lot of that tax benefit or hit goes away through just natural competitive forces.

But I do think it's a negative headline. I think it's optically negative for investor confidence, for corporate confidence, et cetera. In terms of capital gains rate hikes, I think that's a big deal because if you think about it, individual investors have made a lot of money on mega cap tech over the last 10 years. And all of a sudden, if they sell those stocks, and they're taxed at a significantly higher rate than what they were expecting to pay, that might force some selling ahead of potential changes in that tax consequence. So I think that's an area that's particularly vulnerable by the sum of the rhetoric we're hearing in Washington, which is yet another reason that we're not particularly bullish on communication services, on FAANG, on some of these mega cap growth names that have led the market.

BRIAN SOZZI: Well, Julie, it sounds as though maybe I'm right.

SAVITA SUBRAMANIAN: Sorry, Julie. Let's do it. Let's do round two next time.

BRIAN SOZZI: Fair enough. All right, we'll leave it there. Savita Subramanian, always good to see you. Have a great weekend.

SAVITA SUBRAMANIAN: Great to see you.