barometer of financial markets may investment outlook

Just four months into 2021, global equity markets have already hit our targets for the year (returns of 10 per cent). That and tentative signs that economic and corporate earnings growth may be peaking has led us to take some profits. We therefore downgrade equities to neutral, and trim our exposure to cyclical stocks.

Our business cycle indicators suggest the global economy is recovering well from the pandemic, but growth momentum has slowed slightly. That’s particularly true in China, where weaker-than-expected first quarter data has prompted us to trim our 2021 GDP growth forecast there to 10.0 per cent from 10.5 per cent. This slowdown is partly due to a cooling in credit growth. China’s credit impulse, our own measure of credit flowing through the economy,  has dropped off sharply since October is now broadly in-line with its long-term average of 6.5 per cent of GDP.¹ This is in keeping with the view that China will stick to its promise of maintaining continuity and stability in economic policies.

In the euro zone, the recovery is not self-sustaining yet and is fully conditional on successful control of the pandemic, the vaccination campaign and on the persistence of accommodative monetary and fiscal policies. Economic activity in the US, meanwhile, continues to beat expectations – for now. We expect growth to peak in the current quarter, before slowing into the year-end as the fiscal boost starts to fade. Reinforcing our view, a New York Fed survey shows US households plan to spend just 25 per cent of the their stimulus cheques; 34 per cent of the cash will be used to pay down debt and the balance saved.

Fig. 1 - Monthly asset allocation grid

May 2021

Our liquidity indicators show that private credit conditions – credit flowing to household and corporations – have normalised globally. Overall liquidity, however, remains marginally supportive for riskier assets thanks to continued central bank stimulus. However, this support is likely to ease over the coming months. We think that the US Federal Reserve may move faster than expected on tapering QE; it could flag the shift in policy as soon as its June rate-setting meeting.

That, in turn, adds to the case for dialling down exposure to equities – particularly in light of extremely stretched valuations. The total return ratio of US equities versus bonds is now at a historic high, and a staggering 47 per cent above its long-term trend (see Fig. 2). The gap between stocks’ earnings yields and government bond yields, meanwhile, is at its lowest since the 2008 financial crisis.

Fig. 2 - Peak valuation

Total return ratio of US equities versus Treasuries

Globally, stocks’ earnings multiples should come under further pressure in the coming months as monetary stimulus fades. Any further upside for equities will thus have to come from corporate earnings growth. This could indeed continue to surprise on the upside for a while longer, but with investor positioning in – and sentiment towards – stocks already at very bullish levels, any positive market reaction to news of stronger profits is likely to be muted, while weaker-than-expected results could be severely punished.

Technical indicators suggest we are about to enter a three-month long period of negative seasonality for equities (the period running from May to July tends to be associated with weak stock market performance). While investment flows into equities remain strong, the momentum is slowing even if our indicators do not yet suggest stocks are 'overbought'. For bonds, the overall technical signal remains negative.

Global equity markets have already delivered handsome gains since January.

But with their valuations to rising to their highest in more than a decade, stocks will require unusually healthy conditions to continue their rise.

In our view, though, the favourable environment for risky assets may not last much longer.

The pace of global economic growth and the rate at which corporate earnings expectations are rising both appear to have slowed.

To us, that’s critical as it comes ahead of period which has traditionally been a difficult one for stock markets.

What is more, in the face of a rapid economic recovery, the Fed could signal a scaling back of bond purchases in a matter of months.  

US stock markets look particularly vulnerable to a pullback. Not only might Fed policy become less favourable but some aspects of the Biden administration’s spending plans could also weigh on stocks.

Not least his proposal to overhaul the US tax system.

Biden announced plans to nearly double the tax on investment gains for Americans earning more than USD1 million, taking the rate to the highest since 1920s.

The administration also wants to increase tax rates on US companies, which have fallen to the lowest since World War II at 1 per cent of GDP, to fund its USD2.3 trillion infrastructure programme.

According to our calculations, Biden’s tax reform, if fully implemented, could lower corporate earnings by 7-10 per cent, although some of this fall could be offset if stimulus ends up boosting growth. 

A rise in capital gains tax, meanwhile. could have a bigger short-term impact as the top 1 per cent earners – who own almost half of the US stock market – may rush to lock in their USD1 trillion of unrealised investment gains, which represent roughly 30 per cent of average monthly S&P 500 trading volume.

This possibility leaves star US equity market performers of the recent past, such as big tech and other growth-oriented sectors, more vulnerable; less expensive 'value' stocks could benefit.

Elsewhere, we remain overweight Japan, which is attractively priced and whose large export sector should benefit disproportionately from a continued improvement in global trade. 

We remain neutral Europe and emerging markets including China.

Fig. 3 - Cyclical shift?

Valuation of cyclical stocks (ex-tech) vs defensives: rebased to 01.01.2006 relative to manufacturing new orders

If economic growth begins to slow, cyclical stocks may suffer. 

Excluding IT, such stocks are trading at a 15 per cent premium to defensive counterparts on a cyclically-adjusted price to earnings basis – near the top of the historical range. That premium could shrink if, as we suspect, the sharp pick up in manufacturing begins to slow (see Fig.3). 

For these reasons, we downgrade materials to neutral from overweight – the sector is also sensitive to any dip in demand from China, whose economy is expanding less strongly than before. We remain neutral on IT.

Among other cyclicals, we think financials have more room to outperform. Not only is this sector cheap, but if bond yields remain stable or move higher, financials are also likely to outperform. 

We raise real estate stocks to overweight as this attractively-valued sector should benefit from the reopening of the economy; it also offers a reliable hedge against any build-up of inflation.

We maintain our positive stance on US government bonds and Chinese sovereign debt. 

Although troubles are mounting for riskier asset classes, we continue to think US Treasury bonds offer the best returns within developed sovereign bond markets. The market has priced in a Fed rate hike well ahead of the central bank’s own forecast – notwithstanding that officials have been adamant on maintaining a dovish stance.

On the other hand, we expect the Fed to begin tapering its quantitative easing programme of asset purchases in order to give itself more breathing room on interest rates; in other words the central bank does not wish to be forced into premature rate hikes. Tapering could be announced as early as the Fed's June rate-setting meeting or at the Jackson Hole conference in August with the general consensus that any scaling back of bond purchases won't start until early 2022. However, the Fed will find it hard to convince investors of its 'lower for longer' stance if inflation expectations continue to rise (see Fig. 4). 

Within emerging markets, we are overweight sovereign Chinese bonds on grounds of attractive valuations and the fact that they offer diversification benefits. After the economy’s big post-Covid rebound, Chinese authorities are managing a steady normalisation of policy, which should limit inflationary pressures. Meanwhile, growth is starting to shift away from last year’s primarily export-led drivers to domestic demand. If both growth and inflation ease over the long term, this warrants a lower nominal yield in the medium term, while the prospect of a rise in the renminbi, which we estimate is undervalued by some 20 per cent against the dollar, should also boost total returns from the asset class. 

Fig. 4 - Inflation pressures

US TIPS breakeven inflation rate expectations vs real yield, percentage points

Elsewhere, we remain underweight US high yield bonds, where spreads over US Treasuries have fallen to the lows of the previous cycle in late 2018. There doesn’t appear to be much further upside for that asset class. Spreads are at 320 basis points currently and the implied default rate is almost exactly at the same level as the central default expectation. Given that historically the rate implied by market prices has always been higher than the central expectation from Moody's analysts, this suggests investors have no margin of safety in this market.  

On currencies we remain broadly neutral on the US dollar. The Biden administration’s fiscal policy would tend to be supportive of the greenback, but that’s offset by easy monetary policy and some building inflation expectations. 

Strategically though we remain bullish on EM currencies and expect the US dollar to resume its gradual shift lower when the growth outperformance of the US economy comes to an end.

Global equities enjoyed a strong performance in April, adding 3.8 per cent in local currency terms in aggregate, to take their gains for the year-to-date past the 10 per cent mark.

US stocks fared particularly well, with the S&P 500 posting gains for a third consecutive month as investors welcome solid economic data (including a rebound in consumer spending) and better-than-expected corporate profits. With over 300 of US blue chips having already reported first quarter numbers, 87 per cent beat consensus forecasts, according to Refinitiv data. 

UK stocks also fared well, up 4 per cent in sterling terms, as investors welcomed progress on the country’s coronavirus vaccination programme. More than 34 million people have now received at least one dose.

Japan was the only major equity region to finish April in the red, hit by concerns that fresh restrictions to contain a surge of Covid-19 cases will crimp economic growth.

Among equity sectors, the clear laggard was energy, failing to make any headway despite a 7 per cent jump in oil prices. However, it is still by far the best sector year-to-date, suggesting that the April performance could have been a valuation correction.

Fig. 5 - Price surge

Industrial metals and agricultural commodities price indices

 

Materials, in contrast, took heart from an 8 per cent jump in global commodity prices (see Fig. 5). Iron ore prices rallied by more than 30 per cent, while copper reached decade highs thanks to higher demand, exacerbated by previous supply issues.

In fixed income, investors tended to favour higher risk segments. US investment grade and high yield credit each gained over 1 per cent, cheered by the strong earnings. Emerging market debt also held up well. 

US Treasury yields retreated from March’s one-year highs in the face of rising concerns about a peak in economic momentum and with the Fed managing to temper market expectations of a hawkish turn in policy. The yield spread between benchmark 10-year Treasuries and their German equivalent shrank to its lowest level since March 2020, to just 179 basis points. 

The dollar weakened across the board, notching up four consecutive weekly losses against a basket of currencies.