Panorama - May 2021 -
So, who’s got it right? Companies, central banks or governments ?
Deputy Chief Executive Officer,
Chief Investment Officer
Companies have reported very good results and look confident for the coming months. Central banks are sticking to their cautious take, stressing that we are still far from “pre-Covid” activity levels. Governments are piling up debt while promising stronger future potential growth in a “greener” economy but at the cost of heavier taxes and regulations… What are we to make of these divergent messages and what investment strategy is best after a very good start to the year and with markets at all-time highs?
The year got o¡ to a good start, along the lines of 2020, which was a year full of surprises and contradictions. Equity markets continued to rally rather aggressively, with healthy gains on the year to date that are already close to what we had forecast for the entire year, at 10% to 15% for the main indices. The rally has not been derailed by rising bond yields, especially in the United States. On the contrary, the markets continue to be driven by very low interest rates and abundant liquidities provided by central banks and governments, amidst an economic recovery that looks very promising, given how much ground that has to be made up.
That being said, the markets do appear to be running out of steam and are becoming increasingly tentative, with a series of trading sessions with low volumes and little intraday volatility. And no wonder. On the one hand, a pause seems to make sense after the gains that have been accumulated. On the other hand, the future is getting harder to read. What should we believe? The highly optimistic message from companies or the very cautious line being put out by the Federal Reserve, all against a backdrop of heavier and heavier public debt that raises fears ultimately of a world that is more heavily administered, regulated and, especially, taxed.
Companies are highly optimistic. So far, almost 60% of S&P 500 companies have reported their first-quarter results, and those results have been impressive indeed: 87% have beaten forecasts, and year-on-year earnings growth has exceeded 45%, vs. 25% forecast. True, much of this is due to a natural base effect created by last year’s freeze on activity, but it’s breath-taking all the same. Momentum has naturally been driven by a surge in profits in large tech stocks (e.g., Apple and Alphabet), which are the index’s largest caps. Financial analysts have accordingly raised their forecasts for the coming months. All this should work out to 31% earnings growth for S&P 500 companies this year, considerably higher (by 13%) than in 2019. The outlook is also quite good for 2022, with 13% growth forecast. Prospects are also very bright for Europe on the whole, even though tech stocks are far less heavily represented there. Earnings forecasts have also been revised upward, and we are now looking at a 41% increase this year and 15% next year. In Europe, not until 2022 will we exceed the level of 2019. So, visibility is rather good for the next 18 to 24 months, driven by the economic recovery and a natural “catching up” effect.
Therein lies the ambiguity of the messages being sent out by the central banks, especially the Federal Reserve, which is surprisingly cautious amidst this intense phase of recovery. Jerome Powell has taken a very cautious line, insisting on several occasions that there was no risk of inflation, and that the US economy was still far off its pre-crisis level, particular on the jobs front. Well, it sure doesn’t look like it.
In fact, US growth is on track to surpass 7% this year, pushing up commodity and transport prices and triggering shortages in electronic components and labour in some sectors. Meanwhile, the pace of job creations suggests that the unemployment rate is likely to fall below 4.0% as early as yearend. Remember that the unemployment rate had risen to a post-war high, at 14.8% in April 2020, and has now fallen back to 6.0% after a flurry of hiring in recent weeks in services with the vaccination-driven reopening of the economy. For the moment, the bond markets seem to trust Powell. True, long bond yields have risen, quickly at first, but have levelled off over the past several weeks at below 2% on 10-year US government bonds. Keep in mind that bond yields have risen far less in Europe, by only about 40 basis points on the year to date and that the 10-year Bund yield has levelled off within a -0.20%/-0.25% range. So, Powell’s highly cautious line is hard to understand. If he keeps this up, the markets may end up worrying when inflation exceeds 3%, as is highly likely in the coming months. Even though the Fed has flagged and commented on this eventuality, investor confidence could be seriously shaken if inflation says above 3% for several months. On the other hand, a shift in tone or even a tapering (reduction in purchasing programmes) announcement late in the summer would not be a complete surprise in this context. In light of the above, it is hard to predict what the markets will do, but keep in mind how brusquely they reacted to the two previous taperings, in 2013 and 2015. Each time, bond yields spiked by about 100 to 150 basis points, and volatility rose on Wall Street. The euro zone is lagging behind the cycle compared to the United States, due to a tentative vaccination campaign, and the ECB’s tone therefore comes as less of a “shock”. The highly accommodative policy it has flagged does not appear to be completely at odds with what is actually happening in the field.
Central bank caution is also surprising alongside governments’ policies and the “ideological” turn that is beginning to take shape in minds, and – what is most surprising – especially in the United States. Stimulus and investment plans have come one after the other and on an impressive scale. Without getting too much into the details that have already been widely publicised, plans approved or under consideration will amount to almost $6,900bn, equivalent to almost 30% of US GDP. That is an impressive figure especially from the world’s largest economy. This will rase US public debt to almost 130% of GDP, higher even than in France (about 120%) and far higher than in Germany (about 70%). The initial plan was to boost household spending by handing out cheques last year but also to invest in the future in infrastructures and the digital economy and to prepare the US for the energy transition.
This is a praiseworthy goal and should boost the US’s growth potential. The markets took note of the very positive aspect of these investments, which will stimulate economic activity. But there is a less pleasant side. To fund these plans, taxes will have to be raised. There have already been some much-hyped discussions on the taxation, and tax optimisation, of the GAFAMs (Google, Amazon, Facebook, Apple, Microsoft). More generally, Americans will be taxed more heavily, and the corporate tax rate is expected to rise from 21% to 28% in the coming years. So, we appear to be entering an era where fiscal discipline won’t be the priority, where debt will pile up, and where a “debt addiction” could take hold, with public spending earmarked not for investment but to cover the recurring deficits that result from lax management of public finances. And history has shown us that governments are far from being the most e§cient allocators of long-term capital.
Be that as it may, a breath-taking economic recovery is expected in the coming months. On an annualised basis, US growth will be about 10.0% in the next two quarters. This should push it past the current full-year consensus of 6.2%. The euro zone is lagging behind and it will take a later path to recovery than the US. The recovery there will truly begin to accelerate in the coming quarters and will also be less intense, as stimulus is far less aggressive and is taking time to be rolled out. Ultimately, growth could exceed 5.0% in the euro zone, which is slightly above the current consensus forecast of 4.2%. China, in contrast, is ahead of the US in the lockdown-exit cycle. Its economy had reopened before the others, and after a strong rebound in the second half of 2020, the pace of growth is now slowing, particularly in the manufacturing sector. Meanwhile, the government is wary of overall debt levels and is beginning to take measures to rein in lending, particularly in real estate, and to direct it towards small and mid-sized companies. Even so, at around 9%, growth is likely to be far above the government’s 6% low-ball target. Global growth could thus exceed 6% this year, after contracting by almost 4% in 2020. For the moment, it is expected at a little more than 4% in 2022.
In the current market environment, it is also worth monitoring trends in inflation, which will once again become an important parameter. In the United States, it hit 2.6% in March, due mainly to a basis effect on oil prices. When stripping out temporary items, core inflation (inflation ex energy and ex food) remains under control for the moment, at about 1.6% but is likely to accelerate in the coming months for the aforementioned reasons, and headline inflation is likely to exceed 3.0% as early as this summer. For the moment, the full-year consensus is 2.5% and 2.2% for next year, thus suggesting that the markets are not currently pricing in strong inflationary pressures. In the euro zone, inflation rose from 0.8% to 1.6%, while inflation ex food and ex energy slipped to 0.9%. It could rise in the coming months with the recovery in activity and pressures in some segments of the economy. However, it is far from being an issue and is still far from the ECB’s 2.0% target. The consensus forecasts 1.5% for 2021 and 1.2% for 2022.
Central banks’ accommodative stance will not change in the coming months
The Fed and the ECB have several things in common. They remain steadfast in their communication and in the conduct of their respective monetary policies. They agree that higher inflation is being driven by factors that are essentially temporary and that they should not undermine government stimulus plans with an untimely rate hike. Under current conditions, key rates are therefore unlikely to change, at 0.0% in the US and -0.5% in the euro zone. This will keep bond yields from moving up too much, although they are naturally expected to rise alongside the expected economic acceleration. We forecast a 10-year US yield slightly above 2.0% at yearend and a 10-year Bund of about 0.0%. Credit spreads are already very narrow on the whole, and there is little additional room for tightening, whether in investment grade or high yield. The asset class nonetheless continues to be supported by very heavy inflows, particularly from the ECB’s buying programmes. Local-currency emerging market debt has been hit this year by rising US yields and the weakening of a few currencies in countries hit hard by the pandemic. It now looks rather attractive on the whole on a medium-term horizon.
Everything’s going up: earnings, share prices and… valuations
The markets have naturally risen on expectations of the improvement in corporate earnings that is taking shape. Valuations have also risen against a backdrop of stubbornly low interest rates and yield-seeking capital. The current paradox is that the equity market’s “implied” yield (including dividends and share buybacks) is now higher than bonds! For example, European dividend yields are is about 3%, even as more and more companies announce share buybacks, which is one way to return cash to shareholders. The S&P 500 is thus currently trading at 22.6x 2021 earnings and 20x 2022 earnings, based on the latest revisions of forecasts.
This is rather high on historical standards and leaves little room for any further upside and makes the entire market vulnerable to higher interest rates. That being said, there are few alternatives now, given the current lack of attractiveness of the fixed-income markets. The EuroStoxx is currently trading at 18x 2021 forecast earnings, and 16x 2022, which is also rather high by historical standards on this market, albeit less excessive than the S&P 500.
By sector, recovery-exposed sectors continue to make up lost ground and now look close to having completed this process. This looks like the time for a more balanced weightings between the various styles and sectors. In short, we don’t see much additional upside potential in the equity markets in the short term. On the other hand, there are few alternatives.
Our central scenario
We are very tempted to move from “neutral” to “underweight” on equities. But the equity markets are being driven by both monetary and fiscal policies, both of which are very powerful, and it is hazardous to try to fight such support head-on. Even so, everything is rather expensive and we do see so some “complacency” in the markets.
We therefore recommend reasonable equity exposures that are close to strategic weightings but that won’t push portfolios too far into risk zones in the event of a sudden correction and that, on the contrary, will make it possible to reinvest with peace of mine. There are many potential catalysts of a market swoon. We have mentioned several of them, the biggest of which is the possibility of a tapering announcement by the Fed in late summer. We might also add the risk of a resurgence in the pandemic, something that is happening in some countries, even those that have vaccinated high percentages of their populations.
In short, history has shown that investor psychology can shift course rapidly. And it happens that we are now in May. Everyone knows the old adage “Sell in May and go away”, but even old market adages appear to have lost their currency in this “administered” financial world.
Document completed on 06/05/2021
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com