By Tim Sharp, Hottinger & Co.
The key development in Q1 has been the rise in US long bond yields as curves have steepened, leading to the outperformance of financials as shown by the strong Q1 results season for banks. Better than expected earnings per share performances resulted from lower-than-expected loan loss provisions, while strong corporate and investment banking results were supported by sustained M&A activity and private equity gains. We believe the operating environment is likely to remain strong as the developed world starts the reopening process, which should stabilise loan books and increase core fees. Whilst higher bond yields do suggest a reduction in GDP from a macro perspective and a higher discount rate for equities, the stronger outlook that has been the driver of the move in yields is likely to offset these consequences. A main threat that we envisage would be to weaker, indebted, corporates and Emerging Market debt should the dollar strengthen further due to higher yields and improved US growth prospects.
Since the Global Financial Crisis, we have seen the use of cheap debt by corporates to fund financing including share buybacks, and we believe this has led to a major shift in debt vs. equity finance on company balance sheets. Furthermore, due to the level of cheap debt, many private companies have managed to stay private for longer delaying the need for them to seek equity financing or release equity for the founders through IPOs or Special Purpose Acquisition Companies (SPACs). There are signs that this is changing with the number of new SPACs so far in 2021 outstripping 2020 and the increased level of IPOs coming to market could be a sign that insiders wish to take advantage of extremely high valuations. Rising bond yields may give cause for companies to reduce their debt burdens rather than cut CapEx as M&A and equity raising heightens to record levels despite the pandemic[i]. We think an IPO boom would also be good news for bank profits and corporate finance fees as companies look to reverse the de-equitisation theme.
April has seen the start of the Q1 reporting season and S&P500 companies have reported an average 27% upside to analysts earnings estimates so far. Absolute Strategy Research (ASR) is predicting that global and US Q1 earnings could beat 20%, meaning year on year growth could reach 60%, although many are focusing on the Fed’s forward guidance for signs of permanent economic scarring. Interestingly, the share price reaction to such strong results has been the weakest for 25 years, suggesting sustainability of earnings may be a concern particularly given increasing cost pressures[ii]. It may be that companies with pricing power may hold the key. We can see that the strength of the reflation trade, that has led to strong performance in European markets this year, has been partially reversed this month under the pressure of further global outbreaks of Covid-19, the threat posed by potentially vaccine-evasive variants, an asymmetric vaccine roll-out programme and growing geo-political tensions primarily between Russia and the US. This has led to a release of pressure on the US 10-year Treasury yield, dropping from 1.7450 to 1.5452 before settling at 1.6425, and a weakening of 2.10% in the US Dollar Index[iii].
European economies have also been a victim of a surge in Covid-19 cases and a less-than-perfect vaccination plan that has resulted in Brussels seeking legal action against AstraZeneca for limited supply. Although all developed equity markets have had a promising start to Q2, value has underperformed growth meaning the NASDAQ is up 5.6% and S&P500 5.2%, while the Dow Jones Industrial Average has returned 2.7%, UK FTSE All-Share 3.9%, CAC40 3.3% and the Dax 0.9% – where political tensions have taken their tolliii. It may be tempting for certain investors to consider rotating back into expensive, defensive sectors often associated with the 2nd phase of an economic cycle after the reflation trade. However, inflation expectations are pointing higher in Q2, US GDP growth could surprise to the upside for FY 2021, and fiscal stimulus remains firmly on the political agenda, therefore, we continue to favour the reflation trade.
In general, economic data remain strong, especially in manufacturing as the service sectors are still restricted, and ASR point to the relationship between Frankfurt airfreight data and Global GDP. If volumes are maintained at the current levels, ASR expects H1 2021 world trade growth could reach double-digits[iv]. Therefore, while we have seen a reversal in reflation themes over the course of the month it is still early to assume that the cyclical upturn has been fully discounted. Over the course of the month Brent crude prices gained 6.7% and general commodity indexes jumped 7.6% including gold climbing 3.6%iii.
Notably, copper has just moved above $10,000 for the 1st time since 2011 due to increased demand from China but also fresh demand from the rest of the developed world due to the role copper plays in many environmental, “green infrastructure” sectors. The EU Recovery Fund, the US Infrastructure bill, and the focus on COP26 later this year could potentially maintain the demand for copper in the longer term as the metal is expected to play a vital role in the shift from hydrocarbons to sustainable energy sources. As reported in the Financial Times (FT), Goldman Sachs has dubbed copper “the new oil”[v] and ASR reported that the Copper Alliance state that many renewable energy systems use 12 times more copper than traditional systems, while electric vehicles can use 4-5 times more copper than vehicles using the internal combustion engine[vi]. The FT notes that this is only the 3rd time in 20 years that copper could significantly rely on refined inventories to match growing demand meaning that the risk to the price is firmly to the upside.
The IMF amongst others has been concerned about divergent economic performances globally as developed economies open before developing, however, ASR point to global PMI’s that show that 22 out of 24 are higher than a year ago and 16 are up over the last 3 months from January 6[vii]. It is, therefore, likely that the strength of inflation will remain the main risk to financial markets over the coming months which will continue to support the reflation trade. Excess liquidity created by fiscal stimulus plans and above average savings rates will continue to provide support to markets in the short term. The retail ‘Reddit’ phenomenon looks as if it may be more than a passing trend and seeing as amateur traders can be responsible for up to a third of all stock market trading on a given day[viii], we believe that small investors will continue to play an important role in shaping the movements of the US equity markets as well as the increased volatility that goes with their participation. We think the combination of higher nominal GDP and the strength of global liquidity can support higher equity valuations, at least until inflation starts to be a factor, as US indices continue to hit all-time highs.
All in all, the reflation trade took a rest in April as markets began to worry about the pace and shape of the re-opening of the global economy, but we still believe that the risks are to the upside and continue to favour the reflation trade. We feel both equities and bonds remain expensive on an historical basis, but we expect continued support for equities in the medium term with the markets potentially under-estimating global economic strength. We continue to evaluate alternative revenue streams and bond proxies in the light of inflation risks leading to higher bond yields.
[i] ASR Investment Committee Briefing – April 1, 2021
[ii] ASR Equity Strategy – Strongest Earnings Season in 15 yrs – April 29, 2021
[iii] Market data supplied by Refinitiv
[iv] ASR Absolute Insight – The cyclical upswing has further to run – April 20, 2021
[v] Financial Times – Paper Article – Copper dubbed the New Oil – April 30, 2021
[vi] ASR Absolute Insight – The Copper Rally looks Sustainable – April 29, 2021
[vii] ASR Equity Strategy – Q2 Equity Strategy – Focus on Inflation – April 23, 2021
[viii] Financial Times – The Big read – Rise of the Retail Army:- March 9, 2021
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