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Investment Outlook Q3 2021

27th July, 2021

Recent weeks have seen a change of tone in financial markets as bond yields have drifted lower and the leadership within equity markets has switched back to stocks that were the winners in 2020. Does this reflect a change in outlook for the recovery?

Introduction

The early months of the year saw markets reflect a shift in investor preference towards assets that would gain from economic recovery. The vaccination rollouts were seen as the key to the reopening of economies and the return of growth. Stocks such as financials and industrials started to outperform while technology-related stocks, which had driven the market higher in 2020, took a back seat. Inflation became a major concern as bond investors began to fret about excess demand driving yields higher.

In our view, the broadening of equity market leadership was a positive phenomenon and supportive of equity markets. That first-quarter rotation from defensive stocks to cyclical stocks and the move out of bonds has faded in recent weeks as investors have started to question the outlook for growth. The most likely concern here is rising Covid-19 infections and the potential for a return to lockdowns in the autumn.

Delta Variant

In spite of accelerating vaccination programmes, infection rates have started to rise again in some countries in response to the lifting of restrictions and the prevalence of the more infectious Delta variant. This development has raised the spectre of renewed lockdowns potentially slowing the recovery. The UK is an interesting case study as it has a relatively advanced vaccination programme with over two-thirds of the population fully vaccinated and 87% having had one dose at the time of writing. Infection rates in the UK are back up at January levels and some manufacturers, retailers and hospitality firms are experiencing staff shortages due to the requirement for anyone who has been in close contact with a confirmed case to self-isolate.

Nevertheless, the recent increase in infections in the UK has not been reflected in rising hospitalisations. Weakening or breaking the link between the two is essential in maintaining the reopening momentum and sustaining the economic recovery.

So far, it appears that this is the case. The chart below shows the progression of infections and hospitalisations. The link appears to be much weaker since infections started to rise again in May  than it was last year.

 

UK infections and hospitalisations

Source: Our World in Data as at July 13th 2021

The rollout of the EU Digital Covid Certificate for those who are eligible will remove the travel restrictions, including the need to quarantine, that have deterred many from travelling within Europe. This should help the tourism and travel industry rebound in the second half of the year.

In our view, unless a variant emerges that can evade the existing vaccines, the reopening momentum will continue to support economic growth.

When demand exceeds supply

Many of the companies commenting about current conditions are mentioning resource constraints and tight supply chains in certain sectors, including technology, automobiles and construction. While these will clear as the recovery continues, they are currently putting a limit on earnings growth for some companies and raising prices for consumers.

The lack of availability of certain semiconductors, for example, is constraining auto production worldwide. The pent-up demand that has been created by lockdowns and fiscal packages is being released as economies reopen. That demand is now meeting the production setbacks at manufacturers, causing demand to exceed supply. In the US, second-hand auto prices are rising at an unprecedented rate due to the slowdown in new car production caused by the semiconductor shortage.

As we navigate through the second-quarter earnings season, we will get an insight into how companies are dealing with rising input costs and surging demand. Companies with pricing power should feel the tailwind of the improved demand environment through higher earnings. Others are likely to feel the squeeze of higher costs. This includes the cost of hiring and keeping staff. Unfilled job offers in the US are hitting record highs in sectors as diverse as health care, manufacturing, hospitality and education. In response, the percentage of job offers that come with a financial incentive from prospective employers has been rising steadily in 2021. This trend underlines the rising cost of labour as the economy recovers.

The outturn of the first-quarter earnings season was better than investors had expected and estimates for full-year profit growth have been rising steadily. The current earnings season is no less important if momentum is to be maintained in equity markets.

Central banks stay easy

The upward pressure on prices has led to fears among some investors that central banks will raise interest rates to tame inflation. There was a brief rise in yields on the night of the US Federal Reserve’s (Fed’s) June meeting when it was revealed that the number of Fed officials expecting a rate rise in 2022 had increased and that a majority now expects two rises in 2023.

However, officials at the Fed and their counterparts at the European Central Bank have been keen to stress that they view the current rise in inflation as a temporary phenomenon, and that policy will remain very accommodative until the effects of the pandemic are behind us. It is tempting to think that bond investors are buying into this narrative. However, we believe that what we are seeing is an unwinding of a very short position in bonds that was put in place during the growth euphoria that followed the successful trials and subsequent rollouts of the vaccines. We expect yields to be higher by year-end.

Persistence back in vogue

Our Quality model has been reflecting the changes in equity investors’ preferences through the relative performance of the model’s four pillars. The model assigns a quality rank to each stock in a broad universe based on the four pillars of Profitability, Persistence, Protection and People. In the first quarter, the People pillar, which quantifies and ranks how well a company’s management allocates capital between equity, debt and dividends, outperformed. This pillar captures a greater proportion of companies that benefit from economic recovery and could be interpreted as a reflection of investor confidence in the recovery.

Since June, the Persistence pillar, which reflects companies delivering consistent profitability over time, has rebounded and driven our Quality index higher in recent weeks. Persistence of earnings was highly valued during 2020 amid all the uncertainty about earnings and economic growth in general. Companies that could sustain profitability against such an uncertain backdrop were the clear winners. 

Conclusion

Asset markets appear to have become much more circumspect on the growth recovery in recent weeks as bond yields fall and economically exposed stocks underperform. But there is clear momentum building in economies as vaccination rollouts continue and pent-up consumer demand is unleashed. This may pose challenges for some companies facing supply bottlenecks, but this is not surprising given the extraordinary backdrop. Absent a new variant that eludes vaccines, these pressures will abate.

We maintain an active approach to investment. When building equity portfolios, we prefer to focus on investing in profitable companies that deliver consistent results in the long run and allocate capital wisely. That approach is expressed through our investment process, which uses a quantamental approach to identify quality companies with ESG integrated throughout the process.

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