New confirmed cases of Covid-19 have come down significantly from the peaks registered in April and vaccination campaigns have been progressing at an accelerated pace – in developed markets as well as the major emerging markets.
With economies in gradual reopening mode, macroeconomic indicators have become less buoyant, but they remain clearly positive, and corporate earnings prospects are promising. So far this year, earnings reports have been good across the board. According to consensus estimates, the world is looking to achieve a staggering 39% earnings per share growth in 2021. This would come after a rather limited 11% decline of global earnings in 2020, mainly caused by weak European bank earnings. New highs in profits, new highs in markets. Simple.
Although global equities may seem expensive from a multiples perspective (20 times expected earnings, 3 times book value), they look very attractive when compared to bond market valuations. Current price levels still reflect an average earnings yield of close to 5% for the MSCI World Index. Something bondholders can only dream of these days. Meanwhile, emerging markets look even more attractively valued, although this is partly justified by the difficulties some of them are experiencing in recovering from the Covid-19 shock.
What’s more, fiscal and monetary support is likely to remain ample for the time being. While global money supply growth has been slowing, it is still abundant and central banks have done their best to convince investors they will not take the proverbial ‘punch bowl’ away from the current easy money party anytime soon. The Fed’s recent grueling backtracking on a potential hawkish turn, after the market jitters seen in June, is a good illustration.
We simply have to stay bullish, even though we’re well aware that this view relies on central bank cooperation
As dangerous as these very loose monetary policies may seem, from a longer-term perspective, they make it next to impossible to recommend that clients reduce risk at this point. With so much money floating around, any market correction will most likely be met with quick buying. We simply have to stay bullish, even though we’re well aware that this view relies on central bank cooperation.
In fact, both our developed and emerging markets equites teams have kept a positive stance on their respective stock markets for this quarter and have not made any changes to the five underlying factors of our analysis framework. For now, we believe that the current ‘Goldilocks’ environment – with inflation and economic growth neither too high nor too low – will continue for some time.
In the US, government and central bank have successfully pulled out all the stops: another extension of quantitative easing, explosive money growth, massive payroll support and even heftier infrastructure spending. As a result, the economy is back on track, jobs are returning, and consumers’ savings will now be spent in the service economy: masks are off!
In Europe, recent economic news has also been encouraging. Governments seem to focus less on daily new Covid-19 cases, and more on reviving economies and people’s spirits alike, after a rather depressing spring.
In Japan, domestic demand remains lackluster, but the economy is supported by its strong export position in a recovering world. In this context, it is remarkable to see the yen lose ground against a rather weak dollar, and we believe there is upside for this risk-off currency. Unfortunately, we can't use our cheap yen to travel to Japan this summer and watch the Olympics. The Games are on, but spectators will be watching it on a TV-screen.
We also remain upbeat regarding emerging markets, despite their recent lagging performance, as we believe this is partially due to initially slower vaccination rollouts, and because Chinese markets are no longer contributing after a stellar 2020. Now that the Chinese economy has fully recovered and is back to more sustainable growth rates, its equity markets feature a relatively weak earnings outlook for 2021.
That said, the historically high valuation gap – of about 30% – between emerging and developed markets clearly points towards a catchup. Admittedly, valuation multiples typically are lower in emerging markets than in developed ones, but we believe the gap should narrow over time, especially now that increasingly large swathes of the emerging market universe are technology oriented.
So, under these circumstances, what could possibly spoil the equity party this summer? While they may not be our base case, we are forced to consider alternative, less festive scenarios.
Besides a resurgence of the Covid-19 pandemic, one threat for markets may come from the global agreement on the 15% minimum corporate tax rate. Higher taxes are the inevitable flipside of the government largesse we have seen in the Western world. Taxpayers and those that were on the receiving end last year will eventually be asked to foot the bill. And large corporates certainly have been on the receiving end with record-high profitability. So, higher taxation should eventually lead to lower (after-tax) profitability.
Inflationary pressure represents the other elephant in the room. Warning signs have proliferated in recent months, with shortages in several critical areas, such as semiconductors, shipping containers and even in crude oil. Quite a few of the companies we hold in our portfolios have responded by raising prices. Any new evidence on the direction taken by inflation this quarter will be scrutinized in light of what it may mean for monetary policy.
From that perspective, the Fed’s annual ‘central banking party’ in Jackson Hole, towards the end of August, will be of particular interest. Ever since the financial crisis of 2007-2009, markets have become obsessed with every word central bankers utter. So far, major central banks have taken the view that inflation will be transitory and unlikely to cause them to alter their course of action. Indeed, although house prices are still on a tear in many regions, commodity prices seemed to have rolled over already.
For all the recent talk about inflation, we must admit that fast-rising consumer prices have essentially remained a US phenomenon
Also, for all the recent talk about inflation, we must admit that fast-rising consumer prices have essentially remained a US phenomenon. US consumer prices rose 5% year-on-year in May, the fastest pace in nearly 13 years. Elsewhere, however, inflation remains much more subdued. In China and the Eurozone, for instance, consumer prices are rising at around 1% and 2%, respectively. In Japan they remain broadly flat; no inflation here yet.
Finally, one more reason for central banks to hold their horses and not rush to tighten their monetary stances is that accommodative financial conditions will be instrumental in funding the transition towards a low-carbon economy. In times of climate emergency, with colossal investments needed from both the public and private sector in the coming years, this may prove to be the ultimate argument for central bankers to keep money flowing at the expense of temporarily higher inflation.