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Global perspectives: Valuations in the ointment
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During July, global consensus earnings estimates have re-accelerated to the upside, representing another bullish impulse in the tug of war between high valuations on the one hand and strong profits momentum on the other. On a global basis, earnings forecasts have been especially strong in transportation, mining and chemical sectors. We maintain a neutral position on global equities, balancing valuation concerns against still strong earnings momentum but suggest heightened vigilance is in order for the autumn as the prospect of tighter monetary conditions draws closer. As developed market economies return to trend levels of activity, momentum is likely to slow just as central banks take their first steps on the path to policy normalisation.
Despite market worries of a loss of momentum in the near-term, the strong corporate performance being demonstrated in the recent earnings season has once again pushed consensus forecasts for 2021 to a new high. On a weighted basis we estimate that globally profits forecasts are now 5% higher than the pre-COVID levels of January 2021. On an equal-weighted basis global profits forecasts are close to par with pre-COVID levels. The stronger growth for the weighted index reflects the unanticipated surge in profits for the large-cap technology sector during 2020 which has ‘stuck’ as working practices have changed, followed by the 2021 recovery in expectations for the mining and energy sectors.
Despite a number of high-profile earnings misses in the personal and household goods sector, in aggregate there appears to have been relatively little impact to date on corporate profits from exceptionally strong input cost inflation over the past year. All but two of the 25 largest global sectors benefited from upgrades during the past month, with transportation now leading the list as travel restrictions are removed.
We believe that investors are in something of a sweet spot with stimulus packages put in place to counter COVID-19 restrictions still supporting activity while all but the most trivial of public health restrictions to counter the spread of COVID-19 have been removed. The UK’s experience with the ‘delta’ variant for now reflects well on the UK government’s decision to re-open the economy during the summer. We also note that travel restrictions and costly requirements for pre- and post-travel testing and quarantine are being progressively dismantled across Europe.
In the US, the above-consensus non-farm payroll data last week provides evidence of an economy providing the ‘substantial further progress’ required for a normalisation of the US Fed’s monetary policy and tapering of its QE program. This is something which investors will have to digest over H221.
For now, investors remain in something of a sweet spot, even if arguably closer to the end of this benign phase rather than the beginning. Equity markets do not typically fall during a period of earning upgrades and the actual tightening of monetary policy on both sides of the Atlantic remains some time off.
In fact, taken in aggregate broader financial conditions have loosened as real and nominal bond yields have continued to fall and risk premia in credit markets are close to record low levels. This goes a long way to explaining why equity market valuations are currently at a significant premium to average for most global sectors.
Within our neutral stance on equities is however the possibility that an unknown risk (as COVID-19 was in the early days) could yet emerge or some of the known risks such as a more dangerous variant of COVID-19 or an escalation of US/China geopolitical risks could become a reality. Given current valuations, the risk/reward appears unusually asymmetric to the downside. We would also note that despite the good news on earnings over the past month, equities are still trading close to the levels of six months ago on a global basis.