Tuesday Digest

Posted 4 May 2021

Overview: doubling of earnings leaves markets cold
April ended with investors relatively nonchalant about the almost overwhelmingly 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, now going by the unwieldy acronym FANAMATs (Facebook, Amazon, Netflix, Apple, Microsoft, Alphabet and Tesla), the first quarter has been nothing short of a blowout, underlining the almost global dependence on digital services during the winter lockdown. 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 harder it will be to sustain such growth. The other drag for the tech mega caps seems to be concerns that interventions from competition watchdogs look increasing likely to becoming a headwind to further growth. The Chinese government is 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.

‘Sleepy Joe’ reawakens the US economy
After passing the 100 days milestone last week, things are looking good for US President Joe Biden. The US economy grew a very healthy annualised 6.4% during the first quarter, and personal consumption rose by more than 10%. Moreover, 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.

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. 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. However, 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.

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’). Bond yields have risen in recent months as markets have tried to anticipate the Fed’s movement. But this time it might just be different, because 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
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, bringing the global economy to the boil and put upward pressure on prices – most of all in the US. 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.

Inflation and real growth tend to go hand in hand, and 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. Central banks have tried valiantly to reassure markets that a similar policy mistake – tightening conditions too soon – will not happen this time. But 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.