By Tim Sharp
The key questions that are likely to affect investment decisions in the medium-term focus on earnings growth justifying current equity valuations, and the persistent level of inflation accelerating changes in monetary policy. Supply side disruptions have been a significant headwind to growth over recent months, none more so than rising energy prices, and the European gas price shock, which impacts both the growth and the inflation outlook. As we approach COP26 which we believe could have a marked effect on future investment planning; we feel the ability of renewable energy sources to provide consistent supply as the global economy transitions away from traditional energy sources will be key to ensuring minimal supply disruption and fewer such incidents in the future.
COP26 may also indicate a change in the main drivers of future global growth as China’s own change of emphasis in economic development to “common prosperity” could see its prominence as the world’s largest consumer of raw materials superseded by the expected investment in sustainable energy sources. Iron ore and copper have both seen prices weaken as Chinese demand is reduced by its own government directives on energy use and emissions[i] as well as “Dr. Copper’s” ability to react to changes in the global growth trajectory. However, our research suggests copper is likely to be one of the pivotal raw materials in the production of green energy probably ensuring a long-term tailwind for the price.
We believe that it is unlikely that the energy crisis will prove to be anything but temporary, but there are other supply side pressures that may well prove more persistent. The imbalances between the reopening of different sector of economies has thrown up unexpected labour shortages not just in the UK where Brexit fallout is also having an impact, but also well reported in the US. US Wage pressures are now notable, and it is still unclear if the significant levels of people reportedly quitting their jobs or not returning to the workplace after lockdowns, especially in lower income roles, will have a more persistent effect on inflation rates. There is little doubt, in our opinion, that despite the debate regarding the temporary nature of many current inflation pressures, the underlying trend is higher which is probably unsurprising following the unprecedented policy support throughout the pandemic and its lagged effect on inflation.
The ability of central banks to gauge the tightening of policy rates we expect will be scrutinised by investors keen to see global growth recover unchecked by cautious monetary policy decisions. In our view, the recovery from the Global Financial Crisis was dominated by monetary policy and austerity measures, whereas the recovery from the Covid pandemic has been overseen by massive fiscal support leaving rate setters with the dilemma of when to engage monetary levers without choking the recovery.
It is still early in the reporting window for third quarter earnings, but so far reports are above expectations with EPS growth at 32% yoy in Europe and 39% yoy in the US[ii]. Margins are obviously under pressure due to supply side disruption issues which makes the beats the more impressive, and early guidance would suggest that overall firms are seeing demand remaining intact, which could spell good news for the outlook for 2022ii. Absolute Strategy Research (ASR) expect 15-20% yoy global EPS growth over the next 12 months which will continue to drive equity valuations especially if inflation trends lower as the temporary pressures begin to fade, and companies are able to maintain pricing poweri. However, if central bank policy decisions are made too early so as to stifle activity, then we feel investors may start to question valuations once more. Despite recent market trends back into growth stocks when bond yields were unreactive to rising inflation, we remain confident that the reflation trade will prevail emphasised by bond yields that started to move higher in the latter part of the month. ASR point out that rising bond yields tend to favour value over growth, although equity investors really need to see both growth and value perform in a rising market in order to maximise equity outperformance vs. bonds[iii].
Technically, the future for gold should be bright as a storer of value in an inflationary world, however, the gold price is negative 5.4% year-to-date with over $10bn being sold down from the major gold exchange traded funds[iv]. Furthermore, the dollar has revived alongside the US economy putting further pressure on the gold price and leaving investors without the traditional inflation protection that gold has provided. The recent issue of an exchange traded fund that invests in the Bitcoin future has once more pushed the cryptocurrency back into the spotlight and potentially opened the door to more traditional investors to gain exposure. This has led to some investors, most notably Paul Tudor Jones, to see Bitcoin as a portfolio diversifier, and a hedge against inflation particularly as the number of coins that can be mined is limited at 21 million against the unlimited printing presses of central banksiv. However, we believe the rather short and volatile history of Bitcoin’s valuation since 2009 may prove to be its undoing, and more persistent inflation could prove a tailwind for commodity prices, including gold, attracting back investors looking for a more predictable inflation hedge.
Finally, the banking sector seems to be benefitting from an ideal environment for increasing earnings so could be considered as another long only inflation hedge. Over the last week the 5 largest US banks (JPMorgan, Citibank, Bank America, Wells Fargo and Morgan Stanley) have reported consensus beating earnings results helped by high advisory activity, and lower loan loss reserves. All were also remarkably upbeat on the state of the US economy and the financial condition of the US consumer, while supply chain problems were not expected to de-rail the recovery[v]. Moreover, we find European banks are seeing a similar positive environment, and relative valuations are undemanding with most trading well below book values. Asset quality has significantly improved, and we are seeing the highest capital levels since 2008 underlining the general strength of balance sheets. We still favour banks, financials, healthcare, and industrials in equity sectors, but also include sectors that have the power and presence to set market prices, such as large global consumer staples companies which have also featured well so far in this earnings round.
[i] Absolute Strategy Research – October Investment Committee Briefing – October 1, 2021
[ii] Barclays – Earnings beats help alleviate rates pressure – October 22, 2021
[iii] Absolute Strategy Research – The three toughest questions from Q3 marketing – October 14, 2021
[iv] Financial Times – Inflation fears push investors to flee gold for digital currencies – October 22, 2021
[v] Barclays – Earnings to the Rescue – October 19, 2021
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