Goldman sees good year for return on equity, but beware these three risks

Published Mon, Mar 29 20218:52 AM EDT

Bolstered by a continued economic recovery, the S & P 500's return on equity is expected to rebound in 2021, despite three key risks facing the market, according to Goldman Sachs. The Wall Street firm said it believes S & P 500 return on equity, a measure of profitability, will bounce back from its 2020 levels this year, primarily driven by expanding profit margins. "We expect S & P 500 margins will increase to 11.2% in 2021, which should support [return on equity] expansion both at the index level and particularly for cyclical sectors that suffered most in 2020," David Kostin, Goldman Sachs chief U.S. equity strategist, told clients. Return on equity or ROE is a measure of profitability that is calculated by dividing net income by shareholders' equity. Return on equity ended 2020 at 14.6%, its lowest level since 2016. However, amid improving pandemic signs, Goldman expects a rebound in the S & P 500's ROE, despite three key risks. Rising input costs — or the expense incurred to make a product — is the first major risk to achieving higher return on equity, said Kostin. Goldman economists expect that core inflation will peak mid-year and eventually settle near 2% through 2022. However, investors have recently expressed concern about supply chain bottlenecks and input cost pressures. "The ability of companies to pass through rising input costs to consumers will be a key determinant of the trajectory of S & P 500 profit margins," said Kostin. Goldman also said greater interest expense due to rising rates could be a downside risk to return on equity this year. The 10-year Treasury yield is hovering above 1.65% on Monday, up 70 basis points this year. Investors are concerned that companies will not be able to borrow money as cheaply this year amid rising interest rates. Lastly, tax hikes could adversely affect S & P 500 return on equity, said Kostin. "Declining effective tax rates have been the second-largest contributor to ROE expansion during the last 45 years," said Kostin. "In 2020, the median S & P 500 effective tax rate dipped to 18%, the lowest on record since 1975. President Biden has called for higher corporate taxes. As we discussed last week, Biden's proposal would lower S & P 500 [earnings per share] by 9% if enacted in full." Goldman said investors looking to capitalize on the rebound in S & P 500 profitability should consider the firm's ROE Growth Basket. That basket includes names like Netflix, eBay, Procter & Gamble and Pfizer. — with reporting from CNBC's Michael Bloom.

Traders on the floor of the New York Stock Exchange.

Source: NYSE

Bolstered by a continued economic recovery, the S&P 500's return on equity is expected to rebound in 2021, despite three key risks facing the market, according to Goldman Sachs.