Since the market lows triggered by the Covid pandemic in March 2020, returns for risk assets have been stellar. It’s not only the equity market that is behaving in this peculiar way, the economy is too. We are seeing growth in income per capita in major economies, starting with the US, and climbing house prices in the same countries.
To simultaneously process the worst recession since World War II, growing wealth and a dazzling equity bull run requires some mental acrobatics. It’s easy to dismiss the latter as market exuberance or even a bubble, but the reality shows that there is a powerful earnings recovery underway. And where earnings are expected to go, the market follows.
For 2021, our analysts, based on bottom-up, aggregate data, anticipate at least 32% growth in global earnings per share compared to 2020 and 14.2% versus 2019. Asia should lead the regions in a case of ‘first-in, first-out’ of the pandemic. Even sluggish Europe should post higher earnings than in 2019, and only two sectors (energy and industrials), out of eleven, are expected to be less profitable than 2019.
Source: Fidelity International, IBES, 13 March 2021.
Fiscal largesse has piled more debt onto the system, and we could face some sort of bust - a period of rapidly slowing growth - but it would be limited given that central banks are incentivised to preserve low interest rates in order to keep the mountain of debt manageable. The alphabet soup of ZIRP (zero interest rate policy), TINA (there is no alternative) and FOMO (fear of missing out), and the Fed Put are here to stay.
In the long run, debt is a drag on profitability and there is a strong negative correlation between the level of national debt and return on equity. With long-term growth falling in major economies reflecting the challenges of growing the active population and eking out productivity gains, the struggle is uphill.
Note: General government gross debt to GDP 2020e versus trailing 12m return on equity. Source: Refinitiv, March 2021.
With liquidity plentiful and a strong cyclical rebound taking hold, higher real interest rates are not an option as they could choke off the recovery. The balance of risks for equities is therefore to the upside, however, it won’t be a smooth ride. If central banks don’t fight higher inflation there will be volatility and the potential for asset bubbles.
New Zealand seems to be the first authority to start countering bubbles following the beginning of the pandemic. It recently added house price stability to its list of central bank targets following a near 20% rise in property prices in the 12 months to January 2021.
Stock markets are not clear of frothiness either. It’s true that there is little income and expected capital appreciation available elsewhere, for example in bonds, and as a result, we can expect steady inflows into equities, but frenzies such as the one around SPACs are not sustainable. Many of these vehicles are already trading lower than their IPO prices.
With a range of risks facing investors, we will have to remain active and nimble. We cannot revert to what’s worked pre-pandemic or even during the pandemic. The GAFAM (Google, Amazon, Facebook, Apple, Microsoft) companies led over these periods but that doesn’t mean they will be the winners over the next period. We are recovering from the pandemic, macroeconomic policy is shifting, and data points are changing - investment solutions won’t come from looking backwards.
In an investing climate full of cognitive dissonance, we should stick to the primacy of earnings to dictate returns over the long term. Strictly defining and uncovering sustainable earnings growth is the best way for investors to protect against risks."
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