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Investment Outlook Q2 2021

21st April, 2021

Investors have enjoyed further gains so far this year as government and central bank actions continue to support equity markets. The complexion of the rally has changed somewhat and is reflecting confidence in growth mixed with a degree of caution on last year’s winners. What is driving this change?

Introduction

The current equity market rally was sparked by massive fiscal and monetary support and has now been running for over a year. During that period, investors have been prepared to accept that the stimulus packages will overcome the negative effects of Covid-19 lockdowns and return the world economy to growth. We noted in January that there were many reasons to continue to hold equities and bonds through 2021. In the meantime, there have been some developments that have impacted our expectations for the rest of the year.

Figure 1: US Economic Leading Indicator

Source: Institute of Supply Management

The Fed dilemma

Despite clear evidence that the pace of economic recovery is gathering momentum, there has been little circumspection on the part of central bankers. In our last outlook piece from January we wrote that long-term interest rates had been range bound in spite of the US Federal Reserve’s (Fed’s) relatively relaxed attitude to longer rates. That has changed somewhat in the past couple of months. US 10-year yields have broken out of that 0.8%-1.0% range and are currently trading between 1.6% and 1.7%. A succession of Fed officials have expressed a sanguine view of this development. Indeed, Fed Chairman Jerome Powell has said that the move reflects investors’ upbeat view on the economy. For now, it seems, the US central bank is content to control short rates and keep a watch on funding markets, where companies and banks lend to each other, for signs of stress.

The Fed and investors alike will be looking to see if the rise in longer-dated bond yields takes some of the heat out of the housing market, which recovered strongly in the second half of 2020 in response to lower mortgage costs. A tempering of the pace of activity here would lessen the likelihood of an overheating and would probably suit all concerned.

But what if the Fed is wrong and longer rates are actually reflecting an imminent spike in inflation? Powell’s position has been consistent: the Fed is in no hurry  to turn off the liquidity taps, even if inflation were to exceed the central bank’s 2% target. In fact, the Fed is expecting headline inflation to exceed 2% soon, and for good reason. A wide range of commodity prices, particularly oil, have risen consistently since their lows of a year ago and these increases will start to be reflected in inflation calculations.

Apart from these “cost push” factors, many consumers have amassed considerable savings during Covid and are likely to want to spend some of these as restrictions are lifted. The Fed will not act to tighten policy on the basis of headline rates. Based on market rates, investors agree with Powell. The market now expects the 10-year inflation rate to modestly exceed 2%, much as it has done for the past 15 years.

In Europe, where the pace of vaccine rollouts has been significantly slower than in the US, some countries are heading back into hard lockdown and the prospect of inflation remains more remote. Members of the European Central Bank Council have noted the rise of longer-term rates with less equanimity than the Fed. In Europe at least, there is no appetite for tightening conditions.

Paying for the debt

Another recent development concerns US corporation tax, which has potential implications for investors. The equity market barely blinked at the Biden administration’s plan to raise the corporate tax rate from 21% to 28%, which was unveiled alongside the recent infrastructure investment proposals. There will also be provisions to limit the amount of foreign revenues that companies can shelter from the US government in overseas structures.

This should have unsettled investors, who have gained from the corporate tax cuts enacted by the Trump administration. However, in recent days the administration appears to be rowing back from the headline 28% tax rate in order to get the legislation through Congress. This matters as earnings momentum has been very supportive of the current rally.

The MSCI World index has traded at just over 20-times earnings for most of the past year as the market rose in line with rebounding earnings. Without continued vaccine support, that momentum will start to ease as we move through the cycle. Raising corporate taxes on top of this will make it harder for equities to maintain current valuations let alone progress from here. For now, investors have faith in the momentum of the recovery and this is evident in the equity market itself.

The equity rotation

Vaccination programmes had just begun back in January and are now rolling out across the globe. While some countries are further along than others, financial markets are reflecting optimism about the timeframe for a return to some normality. Indeed, the International Monetary Fund (IMF) recently upgraded its global GDP forecast for 2021 to 6.0%, up from 5.5% in January, and expects growth in 2022 to remain at a brisk 4.4%. Of the major economies, the US is forecast to grow at 6.4% as the vaccination rollout continues. China, whose economy was the first to recover from Covid-19, is expected by the IMF to record 8.4% growth this year.

As the market recovered from the Covid-19 shock last March, investors placed great emphasis on the security of company earnings. No other parts of the market could match the technology and internet-related sectors (including working-from-home stocks) for the consistency in profitability they were delivering for investors. These standout performers of 2020 have lost some momentum in 2021, which is a healthy development. We expressed the view that the narrowness of the 2020 rally did not augur well for longer-term equity performance and that a broadening of the market rally was needed for equity returns to be sustained.

That broadening is now happening and has been reflected in sector performance so far this year. The rollout of vaccines has supported optimism over growth, which has helped economically exposed sectors - which lagged for most of 2020 - to begin to outperform. This has seen cyclical sectors, such as energy, financials and industrials, recover some relative performance in recent months.

The People pillar

This “rotation” in investors’ preferences has been evident in our model, which assigns a quality rank to each stock in a broad universe based on the four pillars of Profitability, Persistence, Protection and People. The Persistence pillar dominated performance during the 2020 recovery period as investors sought consistency.

The People pillar, which quantifies and ranks how well a company’s management allocates capital between equity, debt and dividends, has started to outperform in recent months. This pillar captures a greater proportion of those companies that benefit from economic recovery and is reflecting perhaps a greater degree of certainty in investors’ minds regarding growth prospects.

The People pillar has a higher correlation to value stocks, which can be seen in the relative sector weights within its composition. It contains a higher proportion of stocks in the financials, energy and utilities sectors, and tends to be underweight consumer discretionary and technology stocks relative to the other three pillars.

The relative outperformance of the People pillar was seen consistently across the globe. It is also interesting to note that it outperformed the MSCI World despite being overweight technology and underweight financials. This would suggest that while value outperformed during the first quarter, it was the higher-quality value stocks that outperformed the most.

Conclusion

Developments in Q1 have reflected a higher degree of investor optimism regarding the economic recovery. This has been reflected in the composition of equity returns and the underperformance of long bonds – most notably in the US market.

As far as central bank policy goes, this will continue to be supportive of equities and the short end of the bond market. Long bond yields have risen faster than we had expected in January. While there may be more road to travel here, we believe there is a limit to the extent central banks will be prepared to stand back – not least in the US, where the impact of rising relative rates has led to a strengthening dollar.

Equity investors have discounted quite a bit of good news regarding the return to economic normality and may have to endure some loss of momentum in company profits during the current earnings season. Nevertheless, high expectations around the opening up of economies in the coming months are justified as the pace of vaccinations picks up. Meanwhile, we stick to our investment process and focus on high-quality investment opportunities to allocate capital on behalf of our clients.

 

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