Don’t look down

Posted 9 July 2021

Global equities have been on a pretty rapid ascent since the start of the year. This week the world’s investors had a bout of looking down, and a mild attack of vertigo. This dizzyness has been prompted by some reasonable worries. Do we have enough food (earnings growth) to carry on? Is the strong tailwind (in the form of liquidity) about to turn into a headwind? Has one of our party (China) already started slipping back down?

We’ve been going through these thoughts in our quarterly investment committee meetings, and the main conclusion is that things are generally likely to remain supportive for markets. But that is not to say it will be a gentle and comforting climb up the hill.

We have good reason to think the current vaccines are – and will remain – effective. But with the ongoing increase in case numbers, and the Delta variant spreading across both vaccinated and unvaccinated regions, there is a chance of a mutation which could be less impacted by vaccines. Still, in our view, this is not the greatest risk to markets.

There is a potential for monetary and fiscal support to be removed too early, tightening financial conditions before we have moved beyond the COVID bounce. At its last meeting, the policy committee of the US Federal Reserve (Fed) made noises about interest rate moves coming into the far-end of its two-year horizon, and that bond purchases might be less necessary. However, some of the worries revolve around its operational ability, marshalling the day-to-day circulation of money in the US financial system. We take a look at this aspect in an article below.

The slowing of US monetary growth is a mild worry for us. It’s not that liquidity will tighten in an overall way but small disruptions can create risk vortices.

For the developed world, and particularly the US, the increase in the stock of savings has come from government cash handouts and from the rise in asset price values. The US is going through another cash handout at the moment, with a disbursement of child support tax credits. This programme will be longer-lasting than federal support for unemployment, but is also the last of these sorts of payment.

Workers everywhere have been comfortable enough to not rush back into the workplace, but that period is ending. Jobs are plentiful across the developed world, but workers/consumers have shown a little wobble in confidence as they are faced with making sometimes uncomfortable choices. We think this will pass and is at the heart of the path towards normality, and a transition in the mid-phase of an economic growth cycle.

Nevertheless, this easing down from the very strong growth seen in April and May is a factor in slower growth of  US earnings expectations, especially in cyclical companies. The chart below shows JP Morgan’s current run rate of GDP growth estimates and how they’ve changed over 2021.

Liquidity is still plentiful and, even if it is also slowing, it is not contracting. We think that the recent rise in risk aversion has rapidly translated into some quite sharp falls in longer bond yields. At one stage yesterday (Thursday 8th July), the 10-year US bond yield dropped to 1.25%, 30 basis points below the yield after the June Federal Open Market Committee (FOMC) meeting.

Bond yields elsewhere dropped, and virtually all developed world 10-year government bond yields are lower than a week ago by about 10 basis points (-0.1%). Interestingly, such moves have barely touched credit spreads, a situation which provides support for equities despite the slower growth expectations. Relative to corporate bonds, developed market equities look better value than they have done than at any time this year.

This is not true is in China. The slide in growth has been worrying, as much of it has been policy-induced. The sharp unwind of equity markets this week has come immediately after the 100-year Communist Party celebrations, and is fuelled by the authorities’ compression of some large companies. Credit spreads have widened sharply here, unlike the rest of the world.

We had been expecting a reversal in policy direction, and so it came to pass when the People’s Bank of China announced a further reduction in the capital banks need to provide for lending (known as the reserve requirement ratio). The rest of the year is likely to be a bit easier for a lot of the private sector, although perhaps not for companies or owners that become too visible.

Slower growth passages following on from the vibrant bounceback of opening up periods is to be expected. Market worries about central bank policies and declining liquidity growth are also likely to cause some volatility. It could be that a sharp feedback loop provokes worries about “wealth effects” especially in the US, where the more highly valued stocks are abundant.

However, we feel these worries are likely to prove temporary. Growth should stabilise at a strong level during the second half, buoyed particularly by an accelerating Europe. Global jobs growth should become entrenched at a strong level. Equities should remain well supported by continued upward earnings revisions, even if yields start heading somewhat higher again.

The greatest risks centre on hopes for continued global government policy support for investment in infrastructure, jobs markets and training. Investors have less scepticism than usual about governments’ ability to drive the agenda, and the execution. There is no doubt such policies are needed if profit and earnings opportunity are to generate growth above the insipid levels of the past decade. Markets are partially priced for such an outcome, and they could be disappointed.

We remain hopeful, and watchful.

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