Monday Digest

Posted 19 April 2021

Overview: New bond news provides perspective for equity investors
Yields of long maturity bonds across global developed markets fell quite sharply last Thursday, at the same time as economic data showed resoundingly strong activity. This somewhat counterintuitive market action was a very good signal for equity markets, which duly went to new highs in the US, and was viewed as a victory of sorts for central banks. Perhaps they have, at last, succeeded in convincing investors that policy will remain reactive, but without tightening too soon after growth rebounds.

In the US, historically strong growth indicators still cannot yet tell us whether the current pace can be sustained or even will accelerate further. What we can discern is that equity analysts have recently upped 2021 full year corporate earnings estimates sharply, but have been more cautious for 2022. Those are barely changed since the start of the current quarter. Analysts around the world have been increasing their longer-term (generally three-four years’ hence) estimates. Indeed, Factset’s aggregates of longer-term growth projections are at the strongest levels since the data began back in 2001. 

Where longer-term forecasts are concerned, analysts tend to follow markets rather than lead. In other words, one can see the high corporate growth levels as needed to justify current market levels. There is another way to read it: analysts tend to underestimate earnings rebounds, especially during strong economic growth periods, and these longer-term projections are perhaps signalling only that analysts expect to upgrade nearer-term earnings. 

Are we about to experience a ‘gangbusters’ earnings season?
In the US, Q1 earnings reports are beginning to filter through, and to put it mildly, analyst expectations for this particular earnings season are very positive. Earnings per share (EPS) for the S&P500 are expected to post 23.8% year-on-year growth for Q1. This would be nearly 5x the average growth pace of the past ten years, and cannot be dismissed as driven by a base effect, given that in Q1 2020 the US was still largely unaffected by the pandemic.

So far, a raft of statements from the big US banks, including JPMorgan, Wells Fargo, Bank of America and Citigroup reveal strong profit results and outlooks, as well as a significant drop in loan demand. Falling credit demand is usually a bad sign for banks and, indeed, the news caused a slight drop in share prices when it came out. But bank executives are taking it as a good sign. It shows consumers and businesses are in prime shape financially, with borrowers on the whole paying down debts during the pandemic rather than taking on more. This is a far cry from what was feared a year ago, when markets were bracing themselves for widespread defaults.

On a more general note, if the rest of the earnings season is as positive as currently expected (and it usually is better than expectations), it could do a lot of good for markets. As widely known by now, rising equity prices amid a frozen economy has sent valuations (in terms of earnings per share) sky high. If earnings rise in line, those ratios will be brought down towards much more normal levels. Even though none of this should come as a surprise to investors, it should at least take some of the pressure off and alleviate the valuation vertigo we have seen in some pockets of the market.

Further down the line, much depends on what the US Federal Reserve (Fed) will do as growth and inflation come back in force. The Fed has been clear that monetary policy will remain accommodative, but markets currently expect supercharged inflation will cause policymakers to tighten sooner than planned. Rising growth and price rises are all but a certainty, but the key question is whether the Fed sticks with the narrative that price rises will prove transitory. From our perspective, we expect policymakers to stay firm, at least for now. The Fed’s recent policy framework change has moved it to a structurally looser regime, and every signal so far has been that it means what it says. For equities, this is a huge positive, and we should expect even more strong results to follow.

Biden flexes US muscles
The announcement of additional US sanctions against Russia last week – imposed after the hacking of the US cyber security and software company SolarWinds last year – returned geopolitics to the spotlight. The sanctions themselves were widely expected but are more damaging for Russia than the Skripal poisoning sanctions imposed by Trump in 2019. Yet they are small in comparison to the benefit that Biden’s fiscal boost brings for oil prices, and hence Russian oil revenues. Nevertheless, the announcement was a signal that Biden understands his international adversaries are keen to test his mettle, and whether he is as much of a foreign policy dove as he apparently was while part of the Obama administration.

This week’s demonstration of a clear willingness to impose consequences on harmful actions might give those adversaries their answer. With China literally and figuratively pushing its boundaries, and Russia following suit with its military build-up at Ukraine’s borders, Biden’s sanctions are perhaps a warning shot in that direction as well.

We still do not think this will end badly, or that markets will react negatively if tensions between the US and Russia worsen. But beyond the testing of Biden’s foreign policy stance, some see Russia’s actions as pointing to a weakening in Putin’s popularity, with elections of sorts not too far away. The Putin of 15 years ago may have calculated that Russia’s best interests involved a quiet tactical retreat. Older leaders tend to prioritise more personal  incentives towards their legacies, which can lead to more erratic outcomes. This might particularly be the case here, if last year’s speculation about Putin’s health has some basis. 

Markets shrug off German political drama
For well over a decade, Germany’s political system under Chancellor Angela Merkel’s leadership, has looked the picture of stability. But the pandemic is taking its toll. A recent spike in COVID infections, and further tightening of restrictions, has ramped up the criticism of a slow vaccine rollout programme, putting considerable strain on the longstanding grand coalition government. And, with infighting intensifying and Merkel set to resign as Chancellor in September, Germany’s political landscape right now looks anything but steady.

Underlying the drama is an anxiety that the political landscape has shifted away from Merkel’s Christian Democratic Union (CDU) Party – partly due to the pandemic but stretching back much further – leaving it looking stagnant. Merkel’s status-quo centrism has long been appealing to German voters, but the shake-up of recent times has prompted many to look at other options. The Green Party, 30 years ago on the fringes of German politics, has become the new home for urban liberals and the now well-educated children from working class families. This has left the Social Democratic Party (SPD) ailing and promoted the Greens to be Germany’s second-largest party – and looking increasingly likely to be playing a role in forming its next government.

The wider context of all this is a German economy that continues to struggle. The country’s leading research institutes recently cut their 2021 growth forecasts from 4.7% down to 3.7%, prompted by the delayed recovery because of continued lockdowns due to a third wave of the pandemic. All of this is certainly cause for concern – or at least recognition – from markets. But we should temper the negativity somewhat. Ultimately, vaccine struggles should only be temporary, and will fade away once supply ramps up. Meanwhile, even with a compressed growth outlook, business sentiment in Germany is holding up extremely well according to the latest surveys – thanks to the strong global recovery.

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