Monday Digest

Posted 1 March 2021

Overview: earnings expectations may yet stabilise wobbling markets 
The market wobbles of last week brought with them an eerie sense of déjà vu. This time last year, the NASDAQ 100 closed at an all-time high of 9718.73, before sliding back as the far-reaching implications of the pandemic started taking their toll. The pattern has been similar this year, with the NASDAQ 100 reaching another all-time high mid-February, before falling back towards almost exactly the same level as when we started the year. The movements may look similar, but we could not be experiencing a more different set of circumstances. That distinction is apparent when one looks at US long-dated bond yields, which have been going in opposing directions, driven by a starkly different outlook for the US and global economy. 

The answer may partly lie in enhanced expectations of earnings growth beyond next year. Last January, at the peak of expectations, 12 months earnings for the S&P 500 were expected to be $177. Of course, the pandemic put paid to those hopes. Yet, at present, earnings for the next 12 months are, according to some analysts, expected to be only $1 lower, at $176. Which begs the question: “If earnings expectations and long-dated bond yields are where they were last year, why would market levels be different”? 

US Treasury Secretary Janet Yellen has effectively promised to keep fiscal stimulus spending going until employment returns to pre-pandemic levels. Alongside similar affirmative statements from US Federal Reserve (Fed) Chairman Jerome Powell about the importance of continued support, the message is staying positive for longer than has been the case in other recessions. Inevitably, some commentators are now saying the support will be too much, that the US economy will run too hot. In a sense, both Yellen and Powell must hope these commentators will get even more vocal, since an important part of building confidence has to come from a stream of economic positivity. However, it may be that bond investors will get spooked enough to force a rise in yields which threatens to be too costly for the economy, and really tightens financial conditions. At that point, the Fed may have to provide more than warm words.  

So, the current wobbles in equity markets appear to revolve around how yields affect valuations. But for long-term investors, it is always really about earnings, and those remain well supported. Indeed, there is every chance earnings will continue to be pushed up. We therefore won’t get too worried unless yield levels rise enough to really start impacting the real economy. We think that central banks are unlikely to make such a policy error. 

Corporate taxation fast becoming a global fixation  
Ahead of Wednesday’s Budget, media speculation has focused on the likelihood of extending existing support measures, plans to help keep the UK property market bubbling, balanced with warnings about how the Treasury ultimately plans to pay the mountainous bill left by such measures. While continuing to pledge that more support remains essential, Chancellor Rishi Sunak has also been no stranger to fiscally hawkish rhetoric throughout the pandemic, mentioning on multiple occasions that taxes may need to rise, or spending will come down as the world opens up. Yet those often-hawkish noises over the past 12 months have seldom translated into actual policy. Without indulging in the pre-Budget guessing game, we expect (more or less) a similar balancing act this Wednesday.  

While still only speculation, it is perhaps telling that reports suggest Sunak will use a possible corporate tax hike in the US as explicit justification for a similar move here. Janet Yellen has voiced plans to raise America’s business rates from 21% to 28%. But while the Biden administration cites the need to fund an expansive $1.9 trillion stimulus package as one of its reasons for the move, officials have also argued for it on political grounds. Aside from the economics, politicians – and certainly the public – want big business to pay its fair share. Regardless of what one thinks about the benefits of relative levels of corporate taxation, businesses on a global scale have undeniably had a good run in tax terms for quite some time. Globalisation has allowed multinational companies to base themselves practically wherever they like, leading to international competition on tax rates, and a race to the bottom.  

But with public opinion now firmly behind them, US politicians sense an opportunity to go after tax-clever corporates. Given that multinationals are the target, this is an issue that can only be addressed on a global scale – to avoid another race to the bottom on tax rates. Rishi Sunak citing potential US tax changes to justify his own is a great example of this, but we can see it happening almost everywhere. Add to this the European Union’s continued discussion of a financial transaction tax, and the Australian government’s recent payment spat with Facebook, and it seems the taxation tide is turning. Global corporates, particularly those that benefitted from, not suffered from COVID`s activity restrictions may end up with have nowhere left to hide. 

Will the IPO feast leave some shareholders with indigestion? 
Not long ago, market commentators were debating why companies wanted to stay private. Five years ago, Initial Public Offerings (IPOs) were becoming almost old-fashioned, with newer start-ups preferring to stay off the market. That trend has reversed entirely. Not only have a staggering number of new companies come to market in recent months, but many have floated with exorbitant valuations. This is despite the worst global recession on record, and so much uncertainty on when or how many of these companies can generate a profit. An IPO frenzy can often be a sign of financial bubbles forming, but the appetite for budding young businesses clearly reflects optimism about the global economic recovery. So, is the IPO glut a sign of doom or boom ahead? 

Clearly, one cannot disentangle IPO activity from the wider trends within equities last year. New tech companies have had an exceptionally good environment for raising capital. Extraordinary support from central banks has pinned interest rates down to non-existent levels and flooded markets with liquidity. With the risk-free rate of return pushed down so low, the present value of future earnings for companies got pushed higher.  

The IPO surge has come with a boom in the use of special purpose acquisition vehicles (SPACs). Sometimes called ‘blank cheque’ companies, SPACs have no business operations but come to public markets with the intention of merging or acquiring a company with the IPO proceeds. Last year, the number of SPAC IPOs was more than three times the previous record – and the first week of 2021 set a new weekly record. Many have challenged SPAC use by private equity firms to generate fees more quickly, but for now the favourable environment shows no sign of letting up. Interest rates and opportunity costs are low, with most of the IPO cash placed in safe assets like US Treasuries. Even so, the long-term future of SPACs is less certain. Analysis shows that average returns after the merger are much lower than before. Meanwhile, their legal structure allows certain shareholders – those that hold for some time before the merger is announced – to have beneficial investment treatment. As time goes by, this feature may get more airtime and lead to a change in the structure of the SPACs, particularly if the winding down of the IPO boom causes pain for some investors. 

If and when the use of SPACs winds down, the IPO market is likely to cool off, but that does not mean it is a bubble waiting to burst. After all, there is still an abundance of excess cash looking for a home. Most of the recent IPOs came from sectors like IT, technology or biotech. These are structurally strong areas which are certainly not going to go away any time soon – and the long-term tailwinds are still pushing them along. New companies in these areas will always need financing, and investors have shown they are willing to provide it – either through private equity or through IPOs. 

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