Global equity markets have mostly been treading water over the last couple of months, with concerns of higher inflation. Adding to these fears, the latest US inflation numbers came in well above expectations. Markets are now waiting to see if this is just transitory or will be sustained. The good news so far is that global bond yields, which rose sharply in the first quarter have settled for now.
On the COVID-19 front, in the US at least, a large percentage of the population has had at least one vaccination and infections and deaths are down dramatically. Many health experts believe that herd immunity is very close. The vaccine rollout is still lagging in Europe (except for the UK), but the real crisis is in emerging markets, particularly in Brazil and India.
The Australian economy is now bigger than the pre-COVID-19 level and company earnings have also surpassed December 2019 levels. However, the vaccine rollout in Australia has been much slower than in the US. This is not a great situation as it will likely delay the opening of our borders, with the lockdown in Sydney to continue for the foreseeable future.
The global economy should see a big rebound in growth this year, from the contraction of around 3.6% experienced in 2020.
The forecasts of global GDP growth have both been upgraded recently. The OECD projects that Global GDP growth will be 5.6% this year, an upward revision of more than 1% compared to its December outlook. Among advanced economies, the United States is expected to surpass its pre-COVID-19 GDP level this year, while many others are expected to return to their pre-COVID-19 levels in 2022.
Another big piece of economic data was the big miss on new jobs in the US. Markets were expecting around a million new jobs in April, but only 266,000 were created. One explanation for this is the high level of unemployment benefits and school closures forcing parents to stay home. Businesses’ number one concern is the extreme difficulty attracting workers.
According to UBS, consensus earnings per share (EPS) revisions during the February reporting season resulted in EPS upgrades of 5% for the Australian ASX 200, reflecting a recovery to pre-COVID-19 levels. Earnings revisions in the US have been even more dramatic, where companies reported earnings 22.9% above estimates.
However, valuations are well above long-term average levels. Australian equities are trading above 17 times fiscal forecast 2022 earnings while the US market, price to earnings (PE) ratio is above 21 times.
We would expect to see inflation spikes in the 3% to 4% year-over-year range for the US in 2021. This is especially true for April to June when inflation plunged in 2020. If this was to be sustained, it would result in
much higher bond yields and lower PE multiples, and hence lower stock prices. There are some additional factors causing inflation to spike in the short term, including supply chain bottlenecks.
The US Fed believes, and probably the market consensus is, that the spike in inflation will be transitory, and we will soon revert to the benign inflation rates of recent years. This open question would seem to be the biggest risk to equity markets going forward. The main result of higher bond yields so far has been that value or cyclical stocks have been outperforming growth stocks for some months now.
The swing to cyclical stocks should be positive for Australian equities given the proportion of them in our market, such as banks and resources. We do not know how long these stocks will outperform, so we suggest that clients maintain a mix of growth and value/cyclical stocks.
The other major risk to US markets is the big government and taxing policies of the current administration. The expectation is that they will try to raise the corporate tax rate from 21% to 28%, which amounts to more than $2 trillion in extra taxes over 10 years. This will result in earnings downgrades in future years, as well as be negative for employment in the longer term. Massive spending proposals on top of a booming economy are also likely to put upward pressure on interest rates in the short term.
We do not know how many of these measures will get passed, but we do not believe the markets have focused on the risk they pose to markets, especially given the above-average valuations we have right now. Given how far the market has run up and some of the risks we have set out, we are cautious.
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