Amid rising concerns about the Delta variant of COVID-19, markets seem to be moving toward a risk-off mode. This shift has had a notable impact on the fixed income space, with bond yields sliding by 16 bp through July amid a gradual pickup in the VIX level. In equity markets, the Dow and S&P500 indices each sank by 2% on 19 July.
How should equity investors assess these market moves in the context of a strong earnings season so far? Should they be worried? In general, we think there are good reasons why investors should be upbeat about equities for the months to come. Here we elaborate on four reasons as to why we remain sanguine about the prospects of equities for the rest of 2021.
Reason 1: A Return to Lockdown Looks Unlikely
Investors are understandably nervous that authorities may respond to the highly contagious Delta variant with widespread lockdowns. However, there are reasons for optimism on this front. A close look at the data coming out of various regions suggests that even as the Delta variant has taken hold, mortality rates remain extremely low.
Moreover, vaccines appear to be highly effective in curbing the spread of the virus and policymakers are likely to pursue vaccination measures rather than return to extensive lockdowns. With this in mind, the recent 15% to 30% drop in the equity prices of some of the beneficiaries of the reopening – airlines are a prime example – seems overdone, given that we have not seen a meaningful change in the earnings per share (EPS) of such stocks.
Reason 2: Earnings Continue to Drive Returns
As we noted in our mid-year Global Market Outlook, in a refreshing shift, earnings rather than multiples are driving equity returns. This continues to be the case even now with second-quarter EPS tracking strongly in most developed markets. It should be noted that year-on-year earnings expectations for MSCI World over the next 12 months have moved up by 16%, while valuation multiples have barely budged.
At the same time, bond yields have moved down by 40 bp from first-quarter highs, providing a cushion for equity valuations. Equity investors also should take comfort from the fact that the bulk of equity returns in 2021 can be attributed to EPS growth – a substantial change in trend compared with the past two years (Figure 1).
Figure 1: EPS Trumps Other Return Sources Across Major Indices in 2021
All current indications are that this trend is likely to persist. For instance, take second-quarter earnings expectations. Earnings for S&P500 are expected to climb 70% year on year. Granted, these expectations reflect the low base of the second quarter of 2020 — but earnings expectations are still 14% higher now than they were in the second quarter of 2019, and they have steadily trended upward through the second quarter of the current year (increasing by 6% as the second quarter of 2021 progressed).
Reason 3: Prospects Improve for Total Shareholder Returns
The return of buybacks has been a key trend recently, with net buyback activity improving significantly in 2021 after bottoming in the second quarter of 2020. Corporate buyback announcements, typically a leading indicator of buyback activity and corporate confidence, have already exceeded 2020 levels by a wide margin (US$431 billion year to date versus US$307 billion in 2020). Now that the pandemic-era restrictions on buybacks for US banks have been lifted, we could see a further pickup in buyback announcements.
Although executions of announced buyback plans have been slow to rebound, they should show material, sequential growth in the coming quarters. With record profit margins, bloated cash levels and low yields for investment-grade debt, we believe gross buybacks will surpass the prior executed high of US$850 billion.1
At these buyback levels, expected shareholder yield can be as high as 3.9%. With 10-year US bonds yielding 1.2% and US$13 trillion of global debt yielding less than 0%, this represents substantial cross-asset valuation support for equities.
Reason 4: Valuations Become More Compelling
A slide in bond yields has increased the relative attractiveness of equities and equity valuations are now more appealing than they were heading into the first quarter. As an illustration of this point, consider the gap between equity yields and Treasury yields, which is used as a proxy to assess the equity risk premium or the extra return that investors expect from stocks over the risk-free rate.
Over the second quarter, the gap between the two yields has moved by 0.6% in favor of equities. This means investors now are demanding a higher equity risk premium, even though earnings prospects have hardly changed. In other words, equities as an asset class could now be considered cheaper relative to bonds (Figure 2).
Figure 2: Year-to-Date Bond-Equity Yield Gap
With all of these points in mind, we are relatively upbeat about the prospects of equity markets for the rest of 2021. First – although the Delta variant is a serious threat to unvaccinated populations, we believe that the government response is likely to emphasize effective vaccine programs rather than a return to restrictive lockdowns. Second, the welcome trend of earnings driving equity returns appears to be a durable one. Third, prospects for total shareholder return are improving as evident in the boom in buyback announcements this year. And finally, the recent slide in bond yields has made equity valuations even more compelling. For these reasons, we at State Street Global Advisors remain tactically overweight in equities and continue to prefer the asset class for the rest of 2021.
1Profit margins are expected at around 13% in 2022 versus only 11.5% in 2019 for S&P500 companies and approximately US$2 trillion in cash is on the balance sheet of the companies in the index, excluding financials, compared with US$1.6 trillion before the pandemic. The JPMorgan US Liquid Index, which provides valuation metrics for investment grade corporate bonds, yields approximately 2.6% now versus 3.3% before the pandemic.
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