Client Update - 7th May 2021
The world remains almost perfect for equities. Growth is strong and earnings are rising. On both sides of the Atlantic, the pandemic remains the main risk. We are concerned by a slowdown in vaccinations in the US, which may reflect resistance from a significant share of public opinion, jeopardizing swift progress towards collective immunity.
If you were to describe the perfect environment for equities, then today would probably come pretty close. The world is recovering from a massive shock that caused its economy to stall for the best part of a year. Now growth is accelerating as pent-up demand and policy stimulus come together. The economy can run hot because there is slack and getting back to work and rebuilding supply chains are not going to run into insurmountable obstacles – unless the virus comes back in force. The advance estimate of US economic growth for the first quarter of the year was 6.4%. Economists expect that coming quarters will also see very strong growth rates. With that comes a recovery in corporate earnings. The sequential improvements in earnings per share for the S&P500 in Q1 is consistent with the consensus view that growth over the coming 12 months will be in the 20%-25% range. At the same time liquidity is plentiful, household cash has been boosted by saving and Federal aid and flows into equities have been strong. Policy is supportive with very low rates and a series of big fiscal boosts. The US is leading the way, but the same story can be told for Europe – even if the magnitude of the drivers is not quite the same.
The earnings season has so far underpinned the positive story for equities. Earnings have surprised strongly to the upside. Banks reported a second consecutive quarter of strong numbers, helped by the ability to reduce provisions for bad loans. Technology and consumer services companies demonstrated strong growth in revenues. Tech is certainly not dead and the revived performance of “growth” over the last month has been justified by guess what – growth in their earnings. Equities do not yet feel expensive as the way we value companies, the Price (share price) to Earnings ratio (known as the PE number) has remained stable because earnings expectations have moved in line with equity prices. The economic expansion has legs and that means the all-in expected total return from equities, at least for the next year or so, looks superior to any other liquid asset class. And you know what, you can still find relatively cheap equity assets. Both financials and pharmaceuticals trade at a significant price-earnings discount to the S&P in the US market. Europe as a whole looks undervalued relative to the US and emerging markets have lagged and could, at some point, play catch-up once governments finally get on top of vaccination programmes and bring down infection rates.
Logically if it cannot get any better, than it can only get worse. As I have said on many occasions, I am not a great fan of the phrase “it’s all priced in” which, at this juncture, is used as a reason to be bearish on equities. There is nothing new in that, the markets have been described this way on regular occasions since they bottomed on March 23rd, 2020. There will undoubtedly be a correction at some point, but trying to time that is impossible. We could face several more months of rising stock markets, further boosting household and corporate wealth and thus helping sustain the recovery. However, it is prudent to think about the things that might change the outlook. There are clouds on the horizon for sure. At a very basic level, year-on-year equity returns cannot keep running at their recent pace indefinitely.
Anyone that has been fortunate enough to spend any time on holiday abroad will know that there are two types of clouds on the horizon. There are the distant wispy ones that blow along the trade winds in an otherwise pure blue sky. They are there to remind us that nothing can be completely perfect, but they do not pose any immediate threat to the enjoyment of soaking up the sun while sipping a cocktail. Then there are the other clouds on the horizon that begin to look threatening in the distance and then get closer with the inevitability that paradise is going to get disrupted by a huge storm. For now, the clouds are the wispy ones, but there are one or two with darker shades that we have to keep an eye on. In no particular order of importance or timing, those threats to today’s calm come from the balance of policies being pursued by the Biden Administration, the uncertainties around inflation, the scope for ongoing misinterpretation of central bank reaction functions and the inevitable slowdown in growth and earnings momentum that will come after the initial rebound from the pandemic.
On the policy side, the broad observation after the first 100 days of the Biden Administration is that there is a redistributive bias in economic policy. Proposals to raise the minimum wage and create thousands of well-paid “unionised” jobs as part of the infrastructure programme are one side of this. The intention to raise corporate, income and capital gains taxes and to use regulatory forces to change corporate behaviour are the other side. Do not get me wrong, I do not think these things are bad or necessarily represent an overly “leftist anti-business” agenda, but they do mark a break from the policies of the Trump era. Nor do I think they necessarily will come to fruition in their proposed form or that individually or in their entirety they pose a major threat to the economic or market outlook. But some might and if some parts of the programme come to life then there could be an impact on investor sentiment and commensurate market moves.
On inflation I am starting to think it from three different perspectives. The first is that we know base effects and energy prices are going to contribute to a rise in final price inflation in Q2. The second is inflation caused by the supply chain frictions of re-opening. We are seeing this in a number of areas – commodities, shipping freight rates, semi-conductors, building materials and some wage costs. We have never seen such a rapid closure and subsequent re-opening of the world economy as experienced over the last year and the huge swings in activity will have disrupted the supply side. Some businesses have closed, jobs have been lost and production facilities mothballed. Getting everything back to where it was in January 2020 will take time and there will be cost pressures as demand reacts quicker than supply. All of this may contribute to a more prolonged period of higher inflation, but it does not necessarily imply a new inflation regime.
Therefore, the third perspective is the longer-term trend in inflation. It will be some time before we can identify more persistent trends in wage growth, pricing power and inflationary behaviour. A number of trends have been seen to have contributed to the decline in inflation over the last 30 years including globalisation, digitalisation, labour market reforms, demographics, and central bank independence. I am not convinced that they have all reversed.
But the outlook is still that inflation goes up a little this year. That will be met by firmer interest rate dialogue in the market and will require constant strong communications from central banks, primarily the US Federal Reserve (FED). At the most recent FOMC meeting, the FED reiterated that the economy was far from its goals and that the time was not right to begin discussing any change in the monetary stance, including “tapering” asset purchases. The implication of a stabilisation in bond yields is that most of the damage has been done for now (Q1 total return from the US Treasury market index was the worst since the early 1980s).
There are always clouds in the sky but for now the outlook is calm. Companies are ramping up output, hospitality is getting back to serving people, offices are beginning to be occupied and, you never know, there might also be some tentative vacation travel later this year. It is comforting that risks remain, as markets like a bit of uncertainty. But these risks are not right in front of us. April was great for equities; I have no reason to expect May to be any different. But complacency is the enemy of good investing and we need to watch the clouds on the horizon – working out whether they remain wispy or stormy is the challenge for the remainder of the year.