Doubling of earnings leaves markets cold
30 April 2021
After last week’s lull in global equity markets, most regions recovered their previous highs this week, albeit in somewhat lacklustre trading patterns. Just as there were several reasons why markets were in a bad mood last week, there are many reasons for the more positive outlook this week. Those who were most fearful of geopolitical risks will have sounded a sigh of relief when Russia backed down from its threatening build-up of army forces on the Ukraine border, and the relationship between China and the US, appeared more agreeable than contentious at the (digital) climate change summit.
Investors concerned about runaway share price valuations of late have also been relieved by the massively positive corporate earnings growth figures coming out of the US and (to a lesser degree) Europe. In the US, of the S&P500 companies reporting so far (51%), corporate profits grew by an astonishing 57% over the year. In Europe, where 45% of STOXX600 companies have reported, the respective figure is +41%. Given this is even higher than already-optimistic expectations we reported earlier in the month – which cannot be explained away by a base effect given Q1 2020 was still largely COVID-free – it was perhaps surprising stock markets did not react much more positively. However, given how elevated stock markets are, the calm response should be welcomed.
For the US mega-cap tech stocks listed below, the first quarter has been nothing short of a blowout, underlining the almost global dependence on digital services during the winter lockdown. On the other hand, if the very largest companies can grow faster than the average, there might be a competition problem.
That may well be why share price performance generally did not match the growth surprise. The perception is that the more they are seen to be winning, the more vulnerable they are to sustaining such rates of growth.
Against the outstanding levels of their results (bar Netflix) the share price development will have disappointed. There are some strategies they can use to overcome the size effect headwinds they face. Our Investment Specialist Sam Leary points out that Apple’s announcement of a massive long-term capital expenditure programme is such a strategy. He thinks Apple may also try a share buyback later this year – rumoured to amount to as much as $90 billion – but which may not go down as well as investment for future growth.
Apple’s push on privacy is also interesting. As a strategy for offsetting political pressure, giving consumers the ability to stop apps tracking their activity sounds virtuous. Google is also doing something similar. However, this means third-party providers do not get something of value to them – only Google and Apple do – which sounds a bit like “abuse of platform”. This brings us swiftly back to tech market concerns that interventions from competition watchdogs look increasing likely to becoming a headwind to further growth. The Chinese are punishing tech giants Tencent and Alibaba for such moves, which reminds us that global political sentiment is definitely working against the big tech names now.
In the bigger picture, US President Biden’s address to Congress marking his first 100 days in office had the hallmarks of an epoch-changing event. While announcing his third trillion-dollar programme – this one to turn around educational standards and opportunities – Biden broke with the iron principle of US policy of the past 35 years, that the better state is the smaller state. Judging from the positive reception he received, it would appear that recent events have led many US citizens who used to rail against federal government intervention to change their view.
Some journalists even went as far as suggesting the US was adopting the Scandinavian welfare state model. We believe that is quite unlikely given this speech was Biden’s opening gambit – negotiations to get his programmes through Congress will see them watered down. When a government embarks on materially improving the very base of economic growth and prosperity – namely through physical infrastructure and upskilling its broader population – it can only be welcomed by markets. After all, investors want to see the return of sustainably higher growth levels – as long as that does not come at the price of a systematic crowding out of the public sector. Biden’s speech gave no mention of a vision of an overwhelming role of the state, but rather one of re-establishing means and measures that have served the US very well in past – paid for by a tax system where the most wealthy pay the same (but no higher) tax rate as the upper middle class.
We will be following this distinct turnaround in US economic policy with great interest, but we are already pleasantly surprised that Biden – who only last year was considered the dull compromise candidate with his best years behind him – has within just 100 days presented himself as one of the most effective change managers the US has ever voted into office. His predecessor must be furious.
‘Sleepy Joe’ wakes up the US economy
Things are looking good for President Biden as his hundredth day in office passes. The US economy grew by a very healthy annualised 6.4% during the first quarter. While overall growth was a little less than expected, personal consumption accelerated more than 10%. The reason this is not proportionally reflected in GDP growth is because inventories had to be drawn down to satisfy demand amid the problems in supply chains which knocked growth back. As inventories are replenished this should translate into stronger growth for the rest of this year.
In a sea-change from the tumultuous Trump years, the Biden administration has exuded an air of activism and effectiveness as America recovers from the pandemic – and capital markets are fully behind it. The 200 million vaccine doses injected into citizens has given hope that the economy can reopen swiftly, and several huge packages of fiscal stimulus have supercharged growth expectations. Investors, businesses and consumers all appear confident the recovery will continue in force – the latter buoyed by the $1,400 stimulus cheques handed out in recent weeks.
Fiscal policy has played a huge part in the good mood, and will continue to do so as the White House’s spending plans move from emergency support to long-term public investment. But just as important has been the incredible support provided by the US Federal Reserve (Fed). Throughout the pandemic, it has kept interest rates at historic lows and flooded the financial system with liquidity through its asset purchase programme.
Fiscal and monetary stimulus has been so effective at boosting US growth expectations that markets have recently suspected the Fed may have to tighten its policy sooner than it is letting on. Policymakers are showing no sign of backing down, however. After its most recent meeting, Fed Chair Jay Powell dismissed talk of winding down support, even after upgrading the bank’s own forecasts for the economy. “We are a long way from our goals,” claimed Powell, adding that the Fed would respond only to hard data rather than forecasts.
For capital markets, the difficulty is that the hard data is already coming through. Last quarter’s growth figures mean the US economy is slightly larger than it was one year ago, when the pandemic reached American shores, and consumers are in very good shape. Last month, the labour market added nearly one million jobs, bringing the official unemployment rate down to 6%. And judging from consumer confidence levels, the labour market remains buoyant.
The chart below shows consumer confidence stretching back over a few decades, which is closely and inversely correlated with employment figures. Before the pandemic, confidence steadily rose just as unemployment fell to its lowest level in decades – only for the shock of lockdown to send expectations the other way. Now though, consumers are almost as confident as they were before the COVID crisis began. That is understandable, given the artificial nature of many lockdown- related job losses (as travel and leisure industries are expected to hire back workers almost as fast as they laid them off) and the substantial income support provided by the government. But it means the labour market may well be tighter than it looks from the employment figures alone. This is backed up by anecdotal reports that businesses are struggling to find employees – particularly smaller businesses affected by lockdowns.
A tight labour market and booming consumer spending is a recipe for inflation, which is why markets are expecting price increases to ramp up and put pressure on central bankers as we move through the year. But again, the Fed has made it clear it wants to be reactive to inflation rather than proactive, and will allow substantial overshoots of its 2% target to account for past periods of low inflation. This decision is the result of the Fed’s recent policy overhaul, which prompted a re- evaluation of its ‘dual mandate’ (stable prices and full employment) in favour of better promoting jobs and wage growth.
As we have written before, the framework shift makes it difficult to assess how the Fed will react to incoming data. But what we do know is that the central bank wants to give greater consideration to the ‘participation rate’, a measure of how much of the working age population is pursuing employment. Participation rates are certainly still low historically, suggesting workers lack the incentive to join the labour market.
Usually, this disincentive is because of a lack of well-paid or favourable jobs, but this time there could be a different explanation. Household savings have held up extremely well in aggregate through the pandemic, supported by substantial fiscal support, a fall in consumer spending and – crucially – a decent housing market. In short, consumers are in good shape financially, having paid down debts and put money away over the past year. And when savings are high, consumers are much less willing to take whatever job they can get their hands on. If that is true, it would suggest wages will need to rise as the recovery gets underway, to tempt people back into the labour market, or for households to have run down their savings enough as they resume consuming more with the re-opening of the economy.
Let’s take stock of all these factors. We have a central bank committed to keeping things loose, and liquidity abundant for the foreseeable future, a government supporting incomes in the short- term and investing heavily in the future, a population with plenty of savings and high confidence, and an economy finally starting to reopen. Together, these point to a booming 2021 US economy and an uptick in inflation – perhaps even more than is currently expected. How broad-based and long-lasting inflationary tendencies become will depend more on next year’s than this year’s growth. How will the economy react once the sugar rush of reopening has washed through, and the temporary bottlenecks in supply chains have subsided? Much will depend on fiscal and monetary policymakers to carefully manage the transition back to a ‘normal’ economy.
In past episodes, when the US economy recovered from a recession, the natural response was for the Fed to signal monetary tightening down the line – which has tended to result in pre-emptive tightening through markets before the tightening actually happens (the last significant such episode was the 2013 ‘Taper Tantrum’, for those who remember). That is why bond yields rose over recent months – as markets tried to anticipate the Fed’s movement. But this misses the crucial point – the Fed wants to change its ‘natural’ response. The point of its recent policy review was to get rid of a structural bias for low price inflation, and instead promote the share of wages in the overall contributions to GDP – by broadening the workforce through inclusion of all social groups in the labour market. The objective is to shift the emphasis of the US economy from capital to labour, after decades of the reverse. In this sense, the Fed is fully in line with the White House agenda for changing the structure of the US economy. As such, coming out of the pandemic, we can expect not just growth but a different kind of growth than we saw before. Capital owners may perceive this as a threat, but judging by the relative stability in US stock markets, investors seem more concerned with stronger growth lifting all boats than a fraction of investors at the very top end having left a little less once the taxman has had their share.
Insight: Corporate spreads, or how to also value equities
Inflation is a hot topic for capital markets at the moment. Green shoots of an economic recovery are coming through all over the world, and investors are betting on a post-pandemic boom. Meanwhile, both monetary and fiscal policy is expanding, while consumers and businesses are regaining confidence to spend and invest. This is expected to bring the economy to the boil and put upward pressure on prices – most of all in the US (as discussed in the previous article). But what this means for equity markets is not entirely straightforward. At the simplest level, aggregate company earnings are directly related to nominal growth, meaning any move up in prices should be matched by a move up in earnings and – in theory, and over the long-term – an increase in share prices. In this sense, equities are a ‘real’ asset: they give investors a hedge against inflation in a way that fixed coupon bonds cannot.
Looking at a deeper level, though, there are many more factors to consider. Ultimately, the issue comes down to how investors value assets, and in particular how different parts of the ‘accepting risk for the prospect of higher reward’ are priced. ‘Risk premia’ (how much extra reward/return investors will receive over the long term for a given level of risk) is with reference to government bonds – the so-called ‘risk-free rate’.
By working out the difference in returns between government bonds and equities or corporate debt, we can tell how much markets are demanding as a return premium for taking on company risk. However, as a multi-asset investor, we want to work out the difference between corporate bonds risk premia and equity risk premia.
To get a reading of how the market values corporate bond risk, we look at the fixed coupon corporate bond yield less the fixed coupon government bond yield. Trying to transpose this to equities, inflation complicates the picture. Therefore, maybe it is better to try to neutralise it out of the equation. This we can measure by adding together the yield on real government bonds (in the US case, inflation-linked US Treasuries) with the difference (spread) between nominal corporate bonds (in this case, the average of BBB-rated corporate credit) and risk-free nominal government bonds. That gives a measure of the real return on company debt. (This implicitly assumes that the market price of inflation doesn’t have a risk premium, and that discussion is definitely for another time!)
Now, when we put this together with another measure of equity value, we see an interesting relationship. Investors might be familiar with price-to-earnings ratios for equities, which tell us how highly the market values a particular stock relative to its expected profits. But if we flip that equation round (earnings-to-price), it effectively gives us something like a yield equivalent for equities. With valuations currently so high, the inverse is that the equity ‘yield’ is pushed low. This is not so surprising, given that central banks are holding down yields across the world. But the interesting part is how this relates to the ‘real’ corporate bond yields we established in the previous paragraph. The chart below shows the difference between the two measures (spread) – between inflation- adjusted corporate bond yields and the yield investors demand from equities.
As you can see, prior and immediately after the global financial crisis of 2008, this spread moved around a fair amount. But since then, it has been remarkably stable. This is despite the underlying components – equity prices, valuations, inflation, growth expectations, etc. – changing substantially over that time. We think this makes it currently a pretty stable measure of the relative equity risk premium, which means that should one of the other variables change (i.e. corporate earnings or real yields), we can expect share prices to change as well.
Recent historic observation as per the chart above remind us there is a strong relationship between equities and real yields. The implication is that, in itself, inflation is not all that important for equity prices. That is, looking at the broader equity market, inflation is seen by investors as something of a ‘pass through’ in prices – not a great concern, even if everything is pointing to structurally higher inflation.
One shouldn’t take that too far. Inflation and real growth tend to go hand in hand. That is, a big push forward in real growth expectations will tend to be accompanied by a similar move in the price level. So, if long-term inflation expectations rise – all else being equal – so too will estimates for real growth. But these long-term expectations of the real growth of an economy are what drives real yields of government bonds – precisely the factor that ties in so strongly with equity prices.
A sharp rise in real bond yields has stung capital markets in the past, namely the previously mentioned ‘Taper Tantrum’ days of 2013, when a policy misstep from central banks sent real yields sharply higher, driving down risk premia and punishing stock values. Recently, rising real yields have led to similar concerns. Central banks have tried valiantly to reassure markets that a similar policy mistake – tightening conditions too soon – will not happen this time. But the factors discussed above make things tricky for central bankers. By keeping policy loose, they force up inflation expectations, thereby forcing up real growth expectations and, ultimately, real yields.
This has the potential to put pressure on equities, because long-term growth expectations are already at 20-year highs. At the moment, a sharp rise in real yields is one of the main risks to the ebullient mood in markets. We should point out that the relationship between real yields and equities does not have to remain as stable as it has done – not if, say, longer-term expectations of earnings growth swamp shorter-term concerns. But if the stability in that ratio persists, a few things that could happen have the potential to markedly change equity valuations as they stand to today, which are: a shock to real yields after a central bank mistake; a shock to corporate credit spreads after unexpected increases in corporate defaults; or an earnings shock, which would push up earnings yields by earnings increasing unexpectedly fast.
These are scenarios we will have to monitor closely over the coming months – particularly as we come out of the pandemic and the resolve of central bankers is tested. But for now, we can comfort ourselves with the reminder that, over the long-term, equities remain the most profitable asset class, and will ultimately win out if growth is strong.
Please note:
Data used within the Personal Finance Compass is sourced from Bloomberg/FactSet and is only valid for the publication date of this document. The value of your investments can go down as well as up and you may get back less than you originally invested.