Les nuages se tiennent à bonne distance du soleil
The world remains almost perfect for equities. Growth is strong and earnings are rising. Valuations are rich but are not getting worse. Of course, this can’t last for ever. There are concerns over taxes in the US, inflation, interest rates, and the inevitable slowing of momentum. But they 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.
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 quality long-term earnings growers – (guess what?) – growing their earnings. Indices in the US and Europe have traded to all-time highs, but PE ratios have 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 can’t get any better than it can only get worse. As I have said on many occasions, I really don’t like the phrase “it’s all priced in” which, at this juncture, is used as a reason to be bearish on equities or to call for a correction of some time. 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 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 can’t keep running at their recent pace indefinitely.
Anyone that has been fortunate enough to spend any time in the Caribbean 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 don’t pose any immediate threat to the enjoyment of soaking up the sun while sipping a coconut based 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. There is a preference for – at the margin – siding with labour over capital. 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. Don’t get me wrong, I don’t 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.
3 ways to think about inflation
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’ve 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.
So 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. What has changed is that we have new policy compact with both fiscal and monetary policy supporting demand. It is whether this has shifted the aggregate supply-demand balance. Have the last few years of swinging to protectionism done enough to really damage global competition or, in reality, is there still enough goods, capital and labour arbitrage globally to suggest that a serious inflation upswing is not on the horizon? My colleague, David Page, has written on our latest views on US and global inflation Research - The inflation outlook: What’s changed? - AXA IM Global (axa-im.com).
Bonds still nervous
But the outlook is still that inflation goes up a little this year. That will be met by firmer interest rates in the market and will require constant strong communications from central banks, primarily the US 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. My central expectation is that a range of 2.0-2.5% for 10-year Treasury yields is what we are likely to move towards over coming quarters but that this will, in the end, be seen as consistent with economic reality and the expectation that some kind of monetary normalisation will be seen in coming years. It is less lucrative in terms of performance to “short” the bond market today for a move of, say, 50-75bps, than it was with hindsight at a yield of 0.6% a year ago. The implication of that 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).
3% would be a buy
There are other scenarios with other related macro backdrops. A move to 3.0% on 10-year yields would match what happened in the last Fed tightening cycle and would need the Fed to tighten or inflation to accelerate above 2.0% for that to happen. That level of yields, or above, would be nasty for the economy and for the stock market. Such a move could be partly generated by the supply/demand balance in the bond market itself. If the Fed tapers and the Treasury is issuing more, which investors take up the slack of bond buying and does that push yields higher to find the right clearing price? A lower price/higher yield clearing rate for Treasuries would mean the same for credit too. I continue to believe there is foreign demand for higher yielding US Treasuries relative to Bunds, JGBs and Gilts. The US will still absorb a lot of global savings and if its current account deficit increases, which it is, then by definition the current account surpluses of the rest of the world will rise and they will need to be re-cycled. The US Treasury market will be a place where some of that recycled money ends up. We can’t rule out 3% yields in time but if inflation is not going to rise meaningfully above 2.0% then, just as in 2018, this would be a huge bond buying opportunity.
There are always clouds in the sky but for now the outlook is clement.
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. No-one is taking the punch-bowl away for now.
It’s “fun” being a Manchester United fan because, most of the time, the team only wins when it has fallen behind in a game, usually in the first half. It happened again in the 1st leg of the Europa League semi-final against AS Roma. In the end the result was a comfortable 6-2 win which should (fingers crossed emoji) mean an appearance in the final in Gdansk next month. At times, when Pogba, Fernandez and Cavani click, United look invincible. Even more so when the home growth talents of Rashford and Greenwood join in the party. They are not quite, as a team or squad, at the same level as Manchester City, but another year of creating a culture under Ole and adding resources should push them closer to really challenging for the Premier League next year. If only they didn’t put us through the torture of being rubbish in the first half of games.
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