Caution – slowdown ahead

Published on 09/07/2021 Author: Alastair George

To date, 2021 has been as almost good as it gets for equity investors. At the start of the year, portfolio positioning did not require any heroic assumptions on the availability or otherwise of vaccines, as successful trial results were already in the public domain. Instead, a highly conventional assessment that easy monetary conditions combined with a strong economic recovery would push both corporate profits and equity prices higher sufficed. Global equities have now risen to levels above those prevailing prior to the COVID-19 pandemic with both value and growth indices making new records in the year to date. We believe investors now face a conflict between high equity valuations, but positive momentum in corporate profits forecasts. Key to successfully navigating the next 12 months will be determining when the still-ongoing COVID-19 economic recovery will moderate – and just as monetary policy is likely to be tightened.

Purchasing managers’ survey data appears to have peaked in the US and Europe even if it remains at levels indicative of further expansion during Q4. However, in China, we note that some purchasing managers’ indices are already below 50, raising question marks over current level of global energy and industrial metals prices. Given the equity valuation picture, it is in our view time to be increasingly selective on sector exposures and realistic about return expectations in a global equity market where 50% of sectors are trading 35% or more above long-run price/book multiples, Exhibit 1.

Exhibit 1: Forward sector price/book valuations remain extended

Taken in aggregate, recently released global composite PMI survey data suggest that growth rates have reached a seven-month low during August with Japan and China falling into contraction as momentum eases in the US and Europe. To a significant degree this is due to the renewed social restrictions resulting from the spread of the delta COVID-19 variant in Asian countries, which have not been able to achieve the high level of vaccination rates seen in the US and Europe. On the other hand, in the US and Europe some of the recent slowing should naturally be expected as output gaps close. While supply-chain issues and unwelcome input price inflation may ultimately prove to be transient, this is a further headwind to strong growth in developed markets over the short-term and it is catching the attention of ECB policymakers.

The positive rate of change of the OECD’s leading indicator has also moderated somewhat during the summer, with the rate of change of the US composite leading indicator suggesting a slowdown in activity over the next 6 months. The rate of change for other regions remains has also slowed since Q121, Exhibit 2.

Exhibit 2: Global consensus earnings estimates re-accelerate to the upside

Nevertheless, any slowdown in growth has yet to feed into consensus earnings forecasts which have continued to increase over the summer. Earnings revisions have a relatively strong correlation to near-term market direction. In our view history suggests global equities are unlikely to suffer a major setback while consensus forecasts are moving higher. Qualitatively however, it is difficult to see how earnings upgrades can be maintained as the economy slows, which suggests that the upgrade cycle for 2021 is in its closing stages. Indeed, in recent weeks the pace of upgrades appears to have moderated but it is too early to tell if this represents the start of a new trend.

We remain of a neutral view on global equities balancing valuation risks against still-positive economic and earnings momentum but acknowledge that as the economic risks from COVID-19 have diminished, overvalued sectors and markets have become endemic. For now, investors have few high-yielding alternatives for as long as real and nominal bond yields remain at such low levels and corporate credit spreads remain tight. As we look further into 2022 however, we see a significantly more challenging environment for global equities. The list of benign factors for 2021 –

starting valuations, economic momentum and monetary conditions – have progressively swung to being risk factors for 2022.

Exhibit 3: Global consensus earnings estimates remain on upward track

We remain of a neutral view on global equities balancing valuation risks against still-positive economic and earnings momentum but acknowledge that as the economic risks from COVID-19 have diminished, overvalued sectors and markets have become endemic. For now, investors have few high-yielding alternatives for as long as real and nominal bond yields remain at such low levels and corporate credit spreads remain tight. As we look further into 2022 however, we see a significantly more challenging environment for global equities. The list of benign factors for 2021 – starting valuations, economic momentum and monetary conditions – have progressively swung to being risk factors for 2022.