Destination rather than journey
MONTHLY INVESTMENT BRIEF
GLOBAL CO-CIO &
GLOBAL HEAD OF FIXED INCOME
The "reopening of the economy” will drive European and emerging equities up more than US equities, and cyclical shares more than defensive ones, with a bias towards small caps in all regions
In reaction to recent market volatility, we are placing ourselves on a yearend horizon, as the destination is more important than the likely rough journey to that destination.
Why are we optimistic?
- The economic growth outlook is negative in the very short term, but additional fiscal support should provide enough reflation, not only to prevent a contraction in economic activity but also to allow the global economy to accelerate above its potential.
- Herd immunity and the end of social distancing should be enough this year for 2021 consensus earnings and economic growth forecasts to be met. The United States, and not just it, is not yet vaccinating at a pace compatible with achieving herd immunity by this summer, but credible projections of the new Biden administration suggest that the pace will accelerate significantly between now and the end of February.
- On average, households have accumulated heavy savings over the past year (including 15% of disposable income in the US). If these savings were fully deployed after the full reopening of the economy, the output gap would even move temporarily into positive territory. But let’s not dream – the anticipation of possible tax hikes and a permanent reduction in expenditure on some services will keep households from spending all their forced savings.
The question now is whether the reopening of the economy has already been priced into risky assets.
Market forecasts on earnings growth over the next 12 months are already consistent with a closing of the output gap, and analysts forecast aggregate next-12-month S&P 500 earnings per share at about 3% higher than they were at the start of the pandemic.
Does the fact that market expectations already reflect what is likely to happen in the coming year mean that stocks are too expensive? At a minimum, this suggests that doubledigit returns are unlikely, especially as valuations are already stretched. Stretched, yes, but enough to create a bubble?
The trailing Nasdaq Composite P/E is currently 41x, vs. 70x in March 2000 (and almost 25x on average since 1975 when stripping out the 1998-2000 bubble and the 2000-02 deflating of the bubble). So, we are far from the bubble seen back then.
Based on past experience, earnings growth that is in line with, or greater than, forecasts almost always come with positive market performances. Indeed, seldom do equities fall when earnings meet or surpass consensus forecasts, barring a major shock to growth. Earnings met or exceeded forecasts in 1995, 2004-2007, 2010-2011 and 2018, and in this configuration, equities have achieved single- or double-digit returns. Negative year-on-year returns have occurred only seldom and were caused by major shifts in economic outlook, such as the euro zone sovereign debt crisis in 2011-2012 or the start of the Sino-US trade war in 2018.
Exuberance in some asset classes is certainly a warning sign but does not undermine our scenario, as it is highly localised. We’re staying the course. The "reopening of the economy” will drive European and emerging equities up more than US equities, and cyclical shares more than defensive ones, with a bias towards small caps in all regions.