Global equities in a delicate spot

February 26, 2021 09:55
Photo: Reuters

Global equities have had a lot going right for them in the past nine months. An unprecedented easing of monetary policy provided full-blown valuation support, while a succession of fiscal programs around the world helped growth and earnings to rebound quickly. As a result, inflation expectations have rebounded in line with the macro cycle, while real rates retreated to new all-time lows - a boon for equities. Margins recovered and earnings rose, while discount rates continued to fall, boosting valuations and as such, the net present value of rising earnings expectations.

After going through this goldilocks environment, the market is in an increasingly delicate position. Risks are building on both ends: An environment which is too hot may eventually see real rates pick up and bring down multiples – an environment which is too cold could unravel the build-up in expectations for growth being delivered in the second half of 2021. These expectations are best reflected by the fact that global equities have moved ahead of the levels implied by the latest PMI readings, which have softened in every major region in January (on manufacturing and new orders, i.e. what matters for equities). As a result, global PMI momentum has turned negative for the first time since June 2020, contrasting with the move in global equities, which gained 15% over the past three months. Hence, a crack in the current narrative has the potential for a drop in markets.

Usually such a gap between the equity market and macro momentum would make us a lot more cautious than we currently are. The reasons are obvious: Fundamentally, we expect the current weakness in the data to be transitory and project GDP to recover from late Q2 onwards, based on the assumption that lockdown measures are lifted and substantial additional demand is released. Furthermore, a fiscal stimulus to the tune of USD 1.7 trillion is set to pass the US Congress, reinforcing our assumption for US GDP to grow by 6% this year. Taking our forecasts for GDP, rates and the USD, our tactical model for global equities implies close to a 7% upside over the coming six months as a result.

The question which remains is, whether real rates will become a threat to valuations in the months ahead. The most adequate answer is: yes and no! We expect real rates to move higher, but not enough to scare the market. The Fed has been eager to highlight that they are not thinking about policy tightening right now, although inflation expectations are at a six-year high. Their position seems credible, given that (a) their revised policy framework requires average inflation to be at target, allowing for a temporary overshoot, (b) they are very much focused on the labour market, which has been deteriorating lately (-140k jobs lost in December) and (c) the 2013 taper tantrum has significantly raised the Fed’s sensitivity to the impact of their policy on equity markets.

The area where real rates are set to have a more pronounced impact is at the sector level. The combination of rising inflation expectations and gradually higher real rates is set to fuel a recovery in value sectors. In particular banks and diversified financials should benefit, given that they are unmitigated beneficiaries of rising nominal yields, no matter if the increase is driven by inflation expectations or the real rate component. As a result, a Fed policy which aggressively aims to push inflation higher, while letting real rates rise only gradually, may eventually allow banks to outperform after years of trailing the market in an environment of seemingly perpetually declining yields.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin