The big questions for equities

Is the market cycle turning? Are we entering a new phase of growth and policy both here and offshore? This month we look at the ‘big questions’ for equity markets in the period ahead. How much will the inflation outlook matter? Will central bank tapering be a significant headwind? Can improving earnings momentum support equity markets?

The cycle is turning…growth is peaking, policy is less easy

As we turn the mid-year corner in 2021, global and Australian economies look to be on the cusp of a significant transition. Since mid-2020 (despite periodic setbacks), global growth has been recovering at one of its strongest rates in history and policy stimulus from governments and central banks has pushed far beyond levels once considered unprecedented.

However, as H2 2021 begins, the peak of growth momentum has come into view, likely Q3 this year, and central bankers (at the same time government support is fading) are now collectively starting to flag less ‘money printing’ (that is, bond-buying) ahead. Moreover, the strength of the rebound from the 2020 recessionwith 2021 on track to record the fastest growth in 40 yearsis seeing central banks signal a rethink on their telegraphed timing of 2024 for the first hike in rates, now signalling that a start in 2023 is more likely.

While these developments spell greater market volatility aheadturning points always doit’s far from clear that we are transitioning into a phase of the cycle that embodies a sustained pullback in risk markets. Instead, we are on the cusp of a period where growth will be strong (just not as strong as the past year) and policy support will be highly accommodative (just not as ‘easy’ as the past year). Equity returns are likely to remain positive, albeit more moderate, with rotation within sectors and styles more pronounced.

The challenge ahead will be monitoring the extent elevated inflation proves more persistent, arguing for a more rapid removal of easy policy and flagging a faster journey toward tighter policy. This needs to be balanced against the ‘positive’ of some peaking in growth momentum (tempering the inflation impulse and helping supply bottlenecks to ease), as well as central banks early signalling of their intent to remove stimulus, calming markets worried of surprise tightening. Together with periodic setbacks, such as Australia’s current COVID-19 outbreak or potential future geopolitical flare-ups, there are signs the recovery phase, even if less frenetic, has some runway ahead.

Our central case is that equities will remain the asset class of choice over the next six to 12 months and for now, we remain moderately in favour of equities (where strong growth, low-interest rates and earnings momentum should support) relative to fixed income (where modest policy tightening and strong growth should see bond yields trend higher).

As always, the uncertainty associated with turning points are key periods to lean on the discipline of a diversified portfolio. While we are unlikely to be adding more risk (absent an unexpected drawdown), our expectations of easing inflation pressure and peaking growth ahead sees us retain a moderate risk-on stance for now. Persistent inflation or signs central banks are less patient could demand a more neutral position in the months ahead. Regionally, we expect Europe and the UK to outperform the US. Australia remains an overweight, but it is worth noting that, given the strong gains of the banking and mining sectors over the past 12 months, it may also be subject to rotation risks, with healthcare a likely beneficiary.

The big questions for equities in H2 2021

Over the past 15 months, global equities have staged a remarkable rally from their COVID-led lows of March 2020. A combination of large and decisive central bank action, together with a willingness by governments to deficit fund expenditure, resulted in the shortest recession in history. Compared to the tumultuous macro backdrop that equity markets have endured over the past several years (trade wars, US elections, pandemics) investors could be mistaken for thinking the current environment is one of comparable calm. In fact, the VIX (volatility) index has averaged 23.75 so far this year and earlier in June touched its lowest point for the year (15.65), a far cry from the average of 25.75 and low of 20.57 in the second half of 2020.

Despite this, the investing environment, while still broadly positive, is perhaps more difficult now than it has been since the pandemic began. Although every global sector is at least 40% higher since the COVID-19 lows (see chart below), the worst performing sectors from the crisis lows to the US presidential election have been the best performers since then.

The challenge for investors is that although we continue to believe equities can grind higher over 2021, there will likely be a considerable degree of ‘rotation’ within sectors, coupled with bouts of volatility. Tactically though, we believe it still makes sense to remain overweight equities relative to bonds.

We expect non-US equities to outperform over a 12-month horizon as global growth rotates from the US to the rest of the world. Still, investors should not anticipate that equities, nor economies, will grow at the current elevated levels over the next 6-12 months. The US manufacturing index is close to all-time highs and unlikely to expand further.

Historically, the implications are clear: S&P 500 returns have been 6-8% on average when the manufacturing ISM was high (greater than 52.5) and falling. When S&P earnings per share (EPS) growth has peaked but remained greater than 10% for at least 12 months (as UBS expects), S&P 500 annual returns have been close to 11%. But, although overall market returns are positive, there are significant sectoral implications, with cyclicals losing leadership to more defensive allocations, both in the US and Australia.

So how do we feel investors should be positioned if our interpretation of these issues proves correct?

Will inflation be persistent or transitory?

The biggest driver of markets is the outlook for inflation and the coming months will be subject to high inflation prints. For Q2, consensus expects Australian inflation to jump from 1.1% in Q1 to 3.3% in Q2, then fall to 1.8% in 2022. In the US, forecasts are for core personal consumption expenditures to rise from 1.6% in Q1 to 3.0% in Q2 and to not fall back towards 2% until Q2 2022.

The question confronting investors is whether this inflation is ‘transitory’. And perhaps more importantly, what will the US Federal Reserve’s (Fed) reaction be if it does prove to be stubbornly elevated? Thus far, the Fed has made it clear it will not react to higher prices, albeit it is equally clear the era of crisis-policy support is over, and that it, and other central banks, will gradually withdraw stimulus in the year ahead.

For now, the bond market seems to be suggesting that inflation pressures will be transitory. Yields on the US 10-year bond are no higher than they were in February. Also, the break-even inflation curve suggests market participants are in the ‘transitory’ camp (two-year: 2.68%; five-year: 2.41%; 10-year: 2.29%).

If, as we expect, inflation pressures are short-lived, there will be ramifications for how portfolios need to be positioned. A market environment of healthy but slower growth and inflation peaking would likely lead to a ‘bull flattening’ of the yield curve (where long-term rates fall more quickly than short-term rates). This is a market environment that could challenge the reopening trade and other cyclical recovery plays (e.g. consumer discretionary and banks). Instead, investors may rotate back to growth stocks over value. Over the past four months, MSCI Growth has already significantly outperformed MSCI Value, suggesting markets may already be reacting to this potential outcome.

How much of a headwind is tapering to equity markets?

Regardless of how inflation evolves from here, it is likely we are at the beginning of the end for crisis-era monetary policy. Along with the Fed’s most recent commentary, the Reserve Bank of New Zealand, Bank of Canada and Norges Bank have all signalled a move to less accommodative monetary policy. It is quite possible the Reserve Bank of Australia (RBA) will join this group in July, with tapering (i.e. reducing the amount of bond-buying by central banks) becoming a key topic for investors.

Looking back at the 2013 tapering episode, one can observe the following. Despite the focus on the ‘taper tantrum’, developed market equities weathered the process well post the small initial wobble (see the chart below). In contrast, emerging market equities fared relatively poorly, lagging the developed markets. Bond yields were subdued before the tapering announcement and moved significantly higher in its aftermath. Interestingly, they peaked once the actual tapering was implemented. The US dollar was mixed, while gold and commodities were flat to lower.

In terms of sector leadership, there were three distinct phases. Firstly, before the tapering announcement, performance favoured a marginal tilt towards cyclicals over defensives. Secondly, after the announcement, until tapering was implemented, cyclicals performed very strongly versus defensives—especially European financials, industrials and discretionary versus staples and real estate. Notably, commodity equities (mining and energy) did not perform well between the tapering announcement and its implementation. Thirdly, in the six to 12 months after tapering started, leadership turned more defensive, with cyclicals lagging, as did value versus growth.

Can earnings momentum support equity markets?

Ultimately, share prices follow earnings, and with rate risks combining with elevated valuations, EPS growth is a key factor that investors should keep in mind when constructing equity portfolios.

According to FactSet, during the first two months of Q2, expectations for Q2 S&P 500 earnings increased by 5.8% (to $44.42 from $41.97). How significant is a 5.8% increase? Typically, analyst expectations have been revised lower, not higher, by an average of 3.1% over the past 10 years. In fact, this is the largest increase in bottom-up EPS estimates during the first two months of a quarter since FactSet began tracking the measure in 2002. If Q2 earnings growth does increase 61% year-on-year, this would be the highest year-on-year earnings growth rate reported by the S&P 500 since Q4 2009.

This is arguably one of the most important metrics for investors to monitor. If EPS momentum can be sustained, it will provide an important buffer against headwinds for valuation multiples—inflation, interest rates, tapering and taxes. Importantly, as earnings surge, payouts will follow. S&P 500 buy-back announcements have jumped to 2019 levels on a six-month basis, with an imminent pick-up in buy-backs potentially offering support for equities. This is particularly relevant for Australia. Not only are short-term (one-month) EPS revisions among the strongest in the world, but Australia’s status as a ‘dividend market’ may be a positive rather than a negative factor, which it has been of late. Over the past several years, growth stocks have significantly outperformed value and dividend stocks. It is possible that if elevated multiples diminish the prospect of large price gains, high yielders will regain some performance. Australia is a standout in this respect, with the S&P/ASX 50 the highest yielding index across developed markets.

Australia’s net earnings revisions have now been positive for nine months, the longest period in over two decades. It is this combination of yield and EPS momentum that might, in a relative sense, insulate Australian performance versus the rest of the world. Over the past five years, Australia’s two-year forward price/earnings (P/E) multiple has averaged a 2% premium to the MSCI World, compared to its current 1.5% discount. This leaves some room, albeit small, for relative multiples to move higher. But there is a clear inverse relationship between the one-year forward P/E of the S&P/ASX 200 and the local 10-year bond yield. As the RBA looks to exit crisis-era policy and as rates normalise, this will pressure valuations, which means that EPS and dividend per share (DPS) momentum will become important drivers of returns, not expanding multiples. In this respect, domestic equities look well placed.

Other factors to keep in mind

There is the residual risk that a mutation of the virus will delay the growth recovery, as variants of current vaccines are developed. Research shows that COVID-19 variants have reduced the efficacy of existing vaccines, but data also show that vaccines still provide protection against severe cases.

US tax hikes could also weigh on markets. According to UBS, S&P 500 EPS could take a 7.4% hit from President Biden’s proposed 28% corporate (and other) tax hikes. UBS estimates that the increase in capital gains tax could be a 1.5 point hit to multiples (approximately 7%). However, a 50-50 Senate make-up will likely make it difficult to pass the full tax plan.

There are always ‘black swans’. The risk of a geo-political event in the next year remains elevated. Although impossible to anticipate and position for, investors nonetheless need to be cognisant of the possibilities. Front of mind for investors is China’s territorial claims over Taiwan.

This piece was written with contributions from Todd Hoare, Head of Equities

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1 contributor mentioned

Scott Haslem
Chief Investment Officer
Crestone

Scott has more than 20 years’ experience in global financial markets and investment banking, providing extensive economics research and investment strategy across equity and fixed income markets.

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