Author: Alastair George
Investors seem to be ignoring the traditional maxim to sell – or at least reduce risk – at the sound of trumpets. The advent of vaccines means that the COVID-19 pandemic is now becoming viewed by markets as a healthcare problem which can be managed, rather than an economic crisis. Equity markets have risen strongly over the past six months and corporate credit spreads have shrunk to close to 20-year lows. Yet when institutional fund managers return to their offices after the summer, the headwinds of tighter monetary policy and shrinking COVID-19 fiscal support in 2022 will be coming into view. We maintain a neutral view on global equities, balancing still favourable dynamics for value sectors against overvalued growth segments of the market. However we also recognise that the period of rapid gains may be behind us. Equity market valuations are now above average and the rate of upward earnings revisions has faded from the heady levels of earlier in the year.
Exhibit 1: Equity market valuations significantly ahead of long-term averages except for UK
Source: Refinitiv, Edison calculations, Median premium to FY1 Price/book
Normalisation of monetary and fiscal policy on the horizon for 2022
Diminishing economic uncertainty from COVID-19 should give rise to expectations of a normalisation of monetary and fiscal policy during 2022. To date, investors have maintained confidence in asset prices, in large part due to the willingness of policymakers to run policy support at full bore to counter the impact of lockdowns on the economy.
Early in the year, this was a quite logical reason to stay positive on equity markets even as valuations rose above long-term averages. However, while the ‘peak’ monetary impulse occurred much earlier in the pandemic, by 2022 fiscal spending is forecast to contract in advanced economies, according to IMF projections. Budget deficits are forecast to decline somewhat more rapidly than after the financial crisis of 2008 as COVID-19 emergency measures are phased out. Fiscal spending will have to be replaced by private sector spending and investment to maintain the growth momentum.
Furthermore, now the crisis phase of the pandemic is over the traditional political divisions over fiscal policy have returned. For example, US President Biden’s infrastructure spending plan, initially slated as a $2.3trn package now appears to be measured in the US$ billions, as the original proposals met political roadblocks in the the US Senate. Though a return to austerity seems unlikely, rising sovereign debt burdens mean that politicians are starting to pay more attention to fiscal sustainability as the pandemic recedes.
The jury is still out on inflation in our view
Although there has been much discussion on the prospect of rapidly rising inflation, we believe growth risks remain paramount for equity investors at this time. While we would agree that recently sharply rising CPI inflation in developed markets creates inflation uncertainty in the short-term, we believe it is too early to have any confidence this will be more than a temporary phenomenon. In particular central banks will need to carefully parse the data for evidence of “inflation speculation” versus indications of actual inflation. The highly transparent and inevitable disruptions to supply chains, as lockdowns have been imposed and released, have incentivised both investors and corporate buyers to pro-cyclically stockpile commodities creating shortages. Inventory rebuilding is likely to be a significant contributor to recent commodity price inflation which now appears to be easing. For example, lumber prices in the US have fallen by more than 30% since their recent high.
Nevertheless, there is a qualitative argument that a greater degree of fiscal support for the economy may be expected over the coming decade, as green infrastructure initiatives put economies on the path to net-zero. This would at first sight suggest a modestly higher level of inflation and interest rates than investors have become accustomed to over the past 10 years, as former Fed Chair and current US Treasury Secretary Janet Yellen has highlighted. Indeed for a time, the pandemic pushed underwriting growth right to the top of the fiscal agenda for governments in developed markets.
However, we believe central banks will stick to the fiscal figures rather than the narrative. Advanced economy budget deficits as a percent of GDP are expected by the IMF to return to pre-COVID crisis levels by 2023, which suggests that increased talk of a greater role for fiscal policy outside the pandemic has yet to be turned into action. One exception perhaps is the EU’s COVID recovery fund which will turn the EU itself into a major bond issuing entity, rivalling member states, and represents a good example of not letting a crisis go to waste when in pursuit of a policy objective. Nevertheless, the broader fiscal picture is hardly suggestive of radical change. For investors, this indicates that monetary policy can be normalised gradually over time and in our view the risks to growth and inflation remain balanced.
Exhibit 2: ‘Peak stimulus’ in advanced economies
Source: IMF forecasts, Edison calculations. Chart shows G7 aggregate fiscal position
As policy settings are normalised and economic life returns to business as usual we believe investors may have less tolerance for other exceptions, such as sectors trading outside historical valuation norms. As a result, we believe the outperformance of value, cyclical and ‘real economy’ stocks is likely to continue during the second half of 2021. However, the inevitable slowing of the extraordinary rate of current economic expansion is likely to time-limit this trade to H221, as valuations converge. In recent weeks, positive earnings momentum has eased back from the blistering pace set in H121 to more typical (but still positive) rates, which is likely to moderate the pace of equity market returns.
Exhibit 3: Upward earnings revisions have moderated in recent weeks
Source: Refinitiv, Edison calculations
Sitting still can be hard to do. However, the promise of vaccines in developed markets has become a reality and COVID-19 uncertainty is receding. There is good evidence now that the current range of vaccines are effective in preventing hospital admissions, even for the new variants of the virus. As developed markets continue to recover, we remain positive on the value sectors of the stock market, especially in the context of still very low bond yields.
However this is within a neutral view for global equities, due to relatively high valuations for the growth segments of the market. We believe it is too early to declare that inflation is running out of control as the recent data are likely to be highly distorted by the inventory cycle and investor behaviour. Instead, for our portfolio positioning we would be more focused on the risk of a growth slowdown in 2022 as emergency fiscal packages are withdrawn and growth becomes more reliant on private sector consumption and investment.