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Equity markets have been finding the transition to the post-pandemic landscape more challenging than one might have expected. As Covid restrictions fall away and consumer and business confidence improves, the economic recovery should resume. However, in a sense, the recovery has become the problem.
This is an abbreviated version of our quarterly equity outlook
Demand has surged, but supply has lagged due to supply-chain and job market bottlenecks. Prices have risen, more persistently than anticipated. Nonetheless, we believe the disruptions will fade over time, production will recover, and the ‘low-flation’ world we were in before the pandemic will return.
Valuations – too high or about average?
Looking at metrics such as price-earnings, price-book and price-sales, equity markets look expensive. Is this really the case or are things different this time?
An alternative way is to look at the equity risk premium. Today, the ERP is above the average of 5.2%, suggesting S&P 500 valuations are at least fair value if not better.
Interest rates and their impact on value and growth stocks
Movements in inflation expectations and real rates have remained key drivers of the relative performance of the growth and value styles. After another hawkish surprise at November’s US Federal Reserve policy meeting, market expectations for the future level of fed funds rose, contributing to the recent decline in growth stocks.
Since we expect inflation-adjusted rates to climb further, growth stocks could remain under pressure.
Similarly, the comparatively flat performance of US value stocks has over the last several months corresponded with (until recently) stable inflation. Now that expectations are picking up, value stocks may show some gains.
Inflation and margins
We believe the inflation expectations related to supply-chain and labour market constraints are still likely to be temporary. We see tentative signs of easing backlogs in parts of Asia.
The impact on margins varies by sector and in the months ahead, we expect performance to vary more between sectors than between styles.
The IT sector has high margins, so higher input costs are less of a threat to its profits. Materials and industrials companies such as metals and mining, construction materials, and building products companies are better able to pass higher input costs along to customers.
The poor performance of consumer staples is likely due to this being a low-margin business with limited pricing power. In healthcare, prices are often negotiated and difficult to change at short notice. When the input price pressures reverse, as they did modestly last month, these sectors could be the ones most likely to benefit.
This sector breakdown helps explain why the performance of the growth and value styles has changed with respect to inflation and real yields.
- Materials, industrials and consumer staples are all primarily value sectors, so they benefit from rising interest rates, but they respond differently to margin pressures.
- IT and healthcare are largely growth sectors, but they are in different camps when facing higher input costs.
Earnings – Back to normal?
Upcoming earnings reports will be critical as EPS growth rates begin to return to more normal year-on-year levels. S&P 500 EPS growth was 86% in the second quarter from the same 2020 quarter. For this quarter, growth is forecast at ‘only’ 24%. 2022 profits are expected to rise by nearly 8% from 2021.
We should note that earnings surprises were exceptionally high recently, so it is probably inevitable that there will be comparatively more disappointments in the quarters ahead. As a result, we expect some market turbulence. However, a recovering global economy, reasonable valuations, and rising earnings all point to further market gains.
US small caps – Follow the US dollar
A pickup in economic momentum, the return of the reflation trade or a steeper yield curve could be drivers of small-cap outperformance. We believe valuations are attractive. Relative to the broad S&P 500, the forward P/E ratio and equity risk premium are near their lowest since 2004.
The longer-term outlook may depend on the value of the US dollar. Should the dollar weaken further, small caps may resume their underperformance.
Emerging market equities – A mixed bag
The list of headwinds facing emerging market equities is unfortunately long:
- A stronger US dollar
- Rising US interest rates
- Lagging Covid vaccinations
- Regulatory crackdowns and highly indebted property developers in China
- Higher energy prices
- Supply-chain disruptions and labour shortages.
The main factor in EM equities’ favour is comparatively low valuations. In addition, the sustained rise in commodity prices has benefited commodity exporters.
Some of the negative factors should fade in the months ahead. However, developments in China will be critical as the government chooses between supporting growth through increased credit and the desire to reduce debt in the economy. Regulatory action could continue as Beijing refocuses the economy towards high-value added technology hardware rather than software.
Conclusion – Room for further gains
Managing price pressures and operational difficulties will challenge many companies. We expect to see greater differentiation in performance between companies, making active portfolio management propitious.
For equity markets broadly, we see further gains as the economic recovery continues and supply chains unkink. We believe inflation will eventually revert to pre-pandemic trends, meaning that monetary policy, while less accommodative than previously, will not be tightened so much as to cause economic growth to turn negative.