Figure 2: Equity Return Decomposition
With earnings beginning to catch up with stock prices, we continue to see opportunity in equities. In part because the earnings gap is much wider in the United States compared to other regions, where stocks are more reasonably valued, we see the scope of that equity opportunity widening in the second half of 2021 to include European and potentially emerging markets.
An increase in bond yields has nudged equity risk premia lower in recent months, but rising yields have been accompanied by an uptick in inflation, leaving real yields3 little changed and in negative territory. With quantitative easing effectively capping yields, risk assets — including equities — remain attractive.
As outlined in our macroeconomic outlook, we believe US GDP growth has peaked in the first half of 2021, while GDP growth in the eurozone is on the ascent. We expect the growth differential between the US and Europe to narrow toward year end. In general, in periods where US GDP growth compared to the rest of the world declines, equity markets in the rest of the world tend to catch up to the US. With European markets poised to continue their recent outperformance, provided progress toward containing the COVID threat continues, we believe this trend is likely to take shape in the coming months.
Earnings-per-share growth estimates underscore the point. Next-twelve-month EPS growth estimates for Europe are 30.4% — the second highest among major world markets, and ahead of North America by 5.8 percentage points (see Figure 3).
Figure 3: Price-to-Earnings and Earnings-Per-Share Growth
Emerging markets started 2021 strongly, but the rising US dollar and a downshift in relative growth have put pressure on EM equity market returns. As we look to the second half of the year, however, emerging markets warrant attention. EM equity valuations are relatively cheap in the wake of their recent underperformance. Earnings-per-share growth estimates for emerging markets swelled to 36% after a strong Q4 earnings season — the highest in the world. US leading economic indicators tend to be highly correlated with EM outperformance, as US economic growth fuels EM earnings growth and, ultimately, equity prices (see Figures 4a and 4b). We’ve already seen this relationship between US indicators and EM equity prices take shape this year.
Figure 4a: US Leading Economic Indicators YOY Versus MSCI EM Index
Figure 4b: MSCI US Versus China and EM
Within emerging markets, Chinese equities call for particular focus. On a relative basis, Chinese stock valuations are below long-term averages when compared to US stocks; moreover, the twin risks of regulatory action within the tech universe and a slowdown in credit impulse appear to be priced in. Chinese equities are trading below long-term averages relative to the US and the rest of the world (as measured by the ACWI ex-USA IMI index). At the same time, correlations among Chinese stocks and other world markets have fallen in recent periods, which means that Chinese equities offer a diversification benefit.
The reflationary backdrop of 2021 has benefited cyclical stocks. Although we believe the current spike in inflation will be transitory, we are sanguine on cyclicals’ performance. We anticipate continued momentum in cyclicals, driven by the prospect of fiscal spend in the US, along with strong consumption trends stemming from pent-up demand and supply constraints.
As vaccine rollouts continue and countries worldwide increasingly bring COVID under control, we continue to see opportunity in equities, and we believe it’s important to look beyond the immediate headlines to consider all the corners of the globe where those opportunities might reside. As we move through 2021, we believe that strong earnings prospects and less-stretched valuations will continue to add to European equities’ appeal. We foresee continued momentum in cyclical stocks, and we also see opportunity taking shape in emerging markets, which have the highest earnings-growth expectations in the world. Finally, we believe Chinese equities offer particular advantages that certainly justify consideration — and may justify a dedicated portfolio allocation.
Our central thesis for risk assets is arguably the most optimistic we have held in recent years. A strengthening global economy — supercharged by pent-up demand unleashed as economies emerge from lockdown — and ultra-accommodative central banks represent a potent positive combination.
Against this surging economic backdrop, however, markets are laced with signs of fragility. As our Investment Solutions Group (ISG) colleagues point out, the market is currently tiptoeing the line between optimism and complacency, at risk of falling into the latter.4
This complacency is not new, but has reached extreme levels recently, as evidenced by the degree to which economic policy uncertainty now exceeds equity-implied uncertainty (see Figure 5). Looking back on the Global Financial Crisis, we see that equity-implied uncertainty exceeded policy uncertainty by a wide margin. This makes intuitive sense since stock markets price risk quickly and financial crises tend to hit stocks in the first instance. The COVID crisis is very different as it has hit major drivers of the world’s economy, including consumption and trade. Elevated economic policy uncertainty probably reflects the reality that a pandemic can constrict whole economies despite our best policy responses. Relatively low equity-implied uncertainty, then, may simply reflect stock markets’ eagerness to use the template from the last crisis.
Figure 5: Equity Uncertainty vs. Economic Policy Uncertainty
One-Year Moving Average of VIX Index vs. One-Year Moving Average of Economic Policy Uncertainty Index
Complacency may not constitute a risk per se, but it leaves the market in a fragile state, more prone to being rudely awakened by, and overreacting to, the shocks that will inevitably come.
Any number of shocks could shatter the market’s fragile exuberance, from setbacks in progress against the pandemic, to market participants’ failure to appreciate the full import of US President Biden’s tax proposals, to cyberattacks, and to geopolitical conflict, among others. But we believe two risks are worthy of particular focus: the possibility that inflationary pressures become more sustained and entrenched, and the potential that interest rates and bond yields will rise even in the absence of pronounced inflationary pressure, in response to evolving growth or a change in policy.
Key risk: Inflationary pressures become more sustained and entrenched Despite coordinated rhetoric from central banks that inflation is a “transitory” phenomenon (a view we share), inflation risks have undoubtedly moved to the upside, focused in the United States.
The risk is that any move toward the Fed tightening in the market’s fragile state could lead to overreactions; in the extreme, declining asset prices could plunge the global economy back into recession. The Fed could potentially be on the horns of a dilemma, as letting the market “run hot” has historically proven to be a bad idea (see Figure 6). The frequency and severity of negative real returns increase as inflation moves above 5%; this reaction could be magnified after more than a decade of easy monetary policy that has inflated multiples.
Figure 6: Real Annual US Equity Return vs. CPI YoY%
Annually from 1945
What could be the catalyst for inflation to move up and persist at a higher level? In her piece, Putting the Global Inflation Surge in Perspective, Senior Economist Simona Mocuta highlights five possibilities, the most immediate being supply chains/peak globalization. We have already seen evidence of this effect in the global supply of computer chips, particularly from Taiwan. As restricted supply meets explosive demand, the chance of significant price inflation becomes more real.
Inflation would also threaten our rosy view on corporate defaults, as companies without the ability to pass on rising input prices would see their margins squeezed — some to the point of insolvency. In addition, over a longer time frame, corporate equity and inclusion initiatives could cause more corporate profits to be allocated to labor. While undoubtedly a fairer outcome for all, this could also pressure some business models.
Key risk: Interest rates and bond yields rise in response to evolving growth or a change in policy Our base case for bonds is that sovereign yields appear to have reached a ceiling for now, as central banks generally continue to hold policy rates steady. There are, however, some scenarios that may prompt a re-assessment of that view.
If we consider the real yield on US Treasury Inflation Protected Securities (TIPS) a proxy — admittedly a crude one — for real economic growth prospects across the broad US economy, it seems inconsistent that investors would accept a deep negative yield compared with positive consensus GDP growth forecasts. This conundrum is reconciled by the assured appetite of a large, price-insensitive investor in the form of the Federal Reserve.
There is a further unsettling contradiction, however, in a market that has confidence in an economy sustaining inflation at well above 2% per year over the next ten years against a fairly anaemic growth profile (see Figure 7). Naturally this mismatch can be maintained in the short term by investors’ liquidity preferences, relative issuance, and supply of real assets, but a snapback to the real yields of the early 2000s is not inconceivable.
It’s probably fair to assume that policy missteps are more likely to happen at turning points in the cycle, and the Fed has outlined its view of the turning point clearly in its forward guidance. If self-sustaining growth takes shape at a higher level than currently assumed, and the Fed leans toward (even if it does not say) the dreaded word, “taper,” there is potential for extreme volatility. The current experiment of letting the economy run hot places a legitimate question mark over the market’s apparent confidence in a perfectly smooth exit from one of the biggest monetary policy exercises in history. A misstep from the current position could take some time to materialize, but it also seems that the Treasury market attaches a high level of confidence in the Federal Open Market Committee’s communication and navigation skills.
Figure 7: US 10-Year Real Yield and Breakeven Inflation
Which One Is Wrong?
Addressing the Risks
For investors seeking to manage the risks we’ve identified here, we offer the following summary of a few implementation ideas that may prove useful. For more information on our mid-year outlook, key risks, and the approaches we would recommend to help you take full advantage of current opportunities while managing against potential downsides, please contact your State Street Global Advisors relationship manager.
1 Source: JPMorgan, as of May 31, 2021.
2 Source: Bloomberg Barclays Indices.
3 Nominal bond yields less the rate of inflation.
4 In recent weeks, ISG’s Market Regime Indicator has dipped from the “normal” range to the “euphoric” bracket, which can indicate that a degree of complacency is creeping into markets.
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