By Tim Sharp, Hottinger & Co.
Equity markets appear to have stalled during May as the two main catalysts of reopening economies and reflation seem to have run their course in the short term. The MSCI World Index is up 1.26% in dollar terms during the month and despite the continued apparent “buy-on-dip” mentality which is still holding markets firm, the bounces in growth and reopening plays have been shorter lived each time. The S&P 500 outperformed the NASDAQ again in May 0.55% versus -1.53%, but the near-term catalysts do not seem to be enough to drive valuations from here at present. Towards the end of the 1st quarter the correlation between increased volatility and returns was high, suggesting strong risk appetite amongst investors, but this month the same measure for global equity risk appetite is far more neutral[i]. Furthermore, as noted last month, the share price reaction to the Q1 US earnings beats continues to be muted by historical standards as investors look at the guidance for signs that companies will be able to sustain margins[ii]. The question is whether this leads to a broader weakening in risk appetite that would point to a near term high in bond yields.
The European earnings season is by contrast slower to evolve than its US counterpart with 217 out of 600 companies having reported at the time of analysis, however, earnings have beaten expectations by 31% which would be the best result in over a decade according to Absolute Strategy Research (ASR)[iii]. This would point to a quicker recovery than initially expected with year-on-year earnings growth of approximately 150% and the sales-earnings ratio points to a profit margin exceeding pre-pandemic levels. ASR confirm that this would be the highest level for 15 years further underlining our belief in the prospects for European equities[iii]. European equities have had a solid month with EUROSTOXX gaining 1.87%, the CAC 40 gaining 2.83% and the DAX 1.88%.
We believe the UK could be the cheapest of the main equity markets based on historical metrics, with a high weighting towards both value and the reflation trade through energy, basic materials, financials, and consumer staples sectors. The FTSE 100 has had a flat month up 0.76% while the more domestically oriented small cap index gained 1.97%. The vaccination rollout has gone well and the government looks to have strong approval ratings following recent elections, so the domestic landscape in the UK should be attracting investors. We posit that the contraction in Q1 GDP reflected the tighter restrictions following the rapid spread of COVID variants, while statistics suggest a rapid recovery is now underway and that the gap that exists to other developed markets could close by the year end.
Despite warnings from many economists that a transitory increase in inflation should be expected as restrictions ease, the markets have still been surprised by the strength of supply side inflation and an unexpected tightness in labour markets. We are now in a period where base effects will push the annual rate of inflation higher, but we are also witnessing considerable supply chain cost pressures coupled with increases in demand. Although these pricing pressures are expected to dissipate over the coming quarters, markets were jolted by May’s employment report which determined that just 266,000 new jobs had been added versus an expectation of 1,000,000. Many new openings are reportedly unfilled by a workforce that seems unenthused by the prospect of employment[iv].
The pandemic has seen a move from monetary policy responses, such as quantitative easing after the Global Financial Crisis, to an increase in fiscal policy by developed economy governments looking to build an infrastructure capable of supporting the bounce back in global growth. The increase in infrastructure spending has also seen increased momentum in green infrastructure spending, particularly in Europe, in the build up to the COP26 climate summit in November. The need to provide plans on how to achieve the transition to a sustainable world will also highlight the costs to both public and private finances, with ASR pointing to an estimate of $1trn of additional spending per year[v]. Increases in government spending normally lead to a focus on the tax regime for funding. While there is more emphasis on employee welfare and the living wage, it is widely reported that the Biden administration under Treasury Secretary Janet Yellen has been pushing for a landmark agreement that will see a new base in place in the developed world for corporate taxation that will inevitably reverse the trend in lowering the corporate tax burden. This will potentially affect future earnings, increase the pressure on margins, and further add to investors anxieties regarding valuations in our opinion.
The uneven vaccine rollout still seems to be hindering the growth trajectory in many developing countries as countries such as India struggle to cope with hospitalisations. We believe that the disparity that exists in vaccine access could be a long-term drag to global growth and could be detrimental to developed and developing economies alike as the pervasive spread of the virus will significantly heighten the chances of new vaccine-evasive variants mutating. Although the Shanghai SE Composite Index bounced 4.89% in May, Chinese equities have also been weak for most of the year as credit conditions have tightened, restraining economic activity particularly in areas such as real estate. We expect this will influence global growth and may create a headwind for commodity prices in the medium term. Copper eked out a gain of 2.12% after a volatile month while Gold rallied 7.79% again suggesting that perhaps investor risk appetite may be waning.
We have noted on many occasions that historically there exists a negative correlation between equities and bonds and have used this as a reason to hold over-priced government bonds in a multi-asset portfolio. However, at inflection points we see that all asset classes tend to align, and ASR have noted that over the past 3 months the US stock-bond correlation has been at its highest in 20 years at 44%, meaning that on several days of equity weakness over the last month, bond markets have not rallied as expected[vi]. The US Treasury 10yr yield still sits at around 1.58%, similar to where it started May. This positive correlation may point to an increased investor concern at the inflation risk premium and the inherent uncertainty, or it may prove transitory much like the inflation currently being observed in western economies. Nonetheless, we believe it is further proof that bonds do not currently provide the same hedge of equity risk that they once did.
As inflation expectations reach an inflection point, the nervousness in financial markets has led to our continued focus on alternative investments. We are monitoring our existing alternative and multi-asset strategies with a view to comparing them to other options and strategies with lower correlation to traditional asset classes over past periods of volatility to ensure we have the blend of exposures that we currently desire.
[i] Absolute Strategy Research – Risk appetite reaches inflection point – May 26, 2021
[ii] Absolute Strategy Research – Strongest Earnings Season in 15 yrs – April 29, 2021
[iii] Absolute Strategy Research – European Earnings on a Tear – May 11, 2021
[iv] Ft.com – https://www.ft.com/content/73bdd783-ad53-4d78-93d8-39c895b88bc4 – May 27, 2021
[v] Absolute Strategy Research – Investment Committee Briefing – May 3, 2021
[vi] Absolute Strategy Research – The Great Stock–Bond Correlation Conundrum – May 24, 2021
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