Global perspectives: Growth wobble unnerves markets – can UK keep delta in check?

Last month the fear was excessively high inflation but in the first week of July growth fears have come to the fore. A weaker than expected non-manufacturing PMI in the US has triggered a sharp decline in global government bond yields. The US 10y government bond yield has fallen to 1.31%, down from 1.7% in April. We believe equity investors should expect a slowdown in the torrid pace of earnings upgrades, as in aggregate 2021 forecasts on a global basis are now above those prevailing pre-COVID. The delta COVID-19 variant is now spreading rapidly in the UK with rising case numbers in recent weeks. However, it may be different this time, even as restrictions are relaxed. The UK’s vaccination program may have cut COVID-related hospital admissions by a factor of 5 according to our preliminary estimates, which means a surge in cases may not translate into an economy-wide lockdown in the autumn.

Inflation fears subside as growth fears return

If last month the fear was excessively high inflation, the first week of July has brought growth fears to the fore. The US ISM services index came in at 60.4 versus a 66.4 consensus expectation, together with a contractionary ISM employment reading of 49.3. The data highlight that the COVID recovery trade is not a one-way bet and the fastest period of growth may be over. Investor positioning for higher bond yields may have contributed to the rapid decline in US 10y government bond to 1.31% from levels of over 1.7% as recently as April.

Exhibit 1: US 10-y government bond yields decline as growth momentum fades

We believe the lion’s share of the COVID-19 economic recovery has already been embedded in consensus 2021 earnings expectations. On a global basis, in part due to the extraordinary movements in commodity and energy prices 2021 weighted earnings forecasts are now above pre-COVID levels. On an unweighted basis earnings forecasts remain approximately 4% below their pre-COVID level, reflecting the consolidated nature of the resources and technology sectors.

Exhibit 2: 2021 Global consensus earnings forecasts have fully recovered pre-COVID levels

From a sector perspective, comparing pre-COVID 2021 forecasts to post-recovery levels, the key COVID beneficiaries are now mining, paper and energy as commodity prices have surged. The range of sectors which are still forecast to be impacted by COVID is now relatively limited. Travel and leisure or real estate stocks have for example been among last to have social restrictions relaxed. Significant impediments to business and holiday travel remain in place throughout Europe.

Exhibit 3: Pre- and post-COVID compared: 2021 consensus earnings forecasts by sector

We also note that on a global basis there has been a meaningful P/E multiple expansion since pre-COVID levels as markets climb towards record highs in continental Europe and the US. Valuations inform our neutral view on global equities, even in the context of still very low government bond yields.

Early data from UK delta wave is encouraging for release of lockdowns

The UK has proposed a further relaxation of social restrictions during July even as politicians acknowledge a surge in cases may result in the autumn. This is clearly on the aggressive end of the COVID-19 policy spectrum, compared to nations such as Australia. Nevertheless, the early data from the delta-variant wave of infections offers hope that hospitalisations will be well below earlier rates due to the UK’s vaccination program.

Exhibit 3: Pre/Post COVID – earnings forecasts by sector

We have modelled hospitalisation rates from the second wave using an autoregressive method which provides an excellent fit to the hospitalisation data from the second wave. Hospital utilisation lags case numbers and also has a reporting lag of one week.

As the second wave occurred when vaccination rates were much lower, we can apply this model to more recent data to assess the efficacy of the vaccination program. Our preliminary estimates suggest a 5-fold reduction in hospital patients in the ‘delta’ wave. We would attribute this result not only to vaccination but also to the changing demographics of the pandemic, towards younger unvaccinated patients which are less likely to suffer serious infections.

It remains too early to be sure but this data is suggestive that as case numbers increase into the autumn an uncontrollable surge in hospital admissions may be avoided. If this is the UK experience, other European nations may follow suit.

Still neutral on global equities

Global equity markets on a valuation basis appear fully up with events as consensus earnings forecasts and P/E multiples are both higher than pre-COVID levels. The recent weaker than expected US ISM data suggest that we have passed the peak in growth momentum in the US, which would be consistent with the observed slowing in the pace of upward earnings revisions for 2021. However, in the absence of any known trigger for a reversal in market sentiment and still very low government bond yields we believe markets are likely to remain supported at current levels. With volatility low, credit market spreads remain tight providing private equity with the ammunition to explore deals. As a result, debt-financed M&A activity is also gaining pace in equity markets, providing further support for equity market sentiment.