When we wrote the Top Down last month, we were in the middle of a mild tremor in equity markets. Since then confidence in the economic recovery has been restored. So far this month world equities have returned about 7% and are back to all-time highs. We believe they have further to go. Why are we so optimistic? The driver will be an economic growth rate that exceeds current forecasts and a corporate sector that is converting that economic growth into profit growth at a faster rate than it has in the past.
Why are we so optimistic about an accelerating economy?
The main driver of our optimism is the policy mix that we are seeing evolve across the globe. In the last cycle before the pandemic struck there was a lot of discussion about the low level of economic growth that was being generated across the globe. In real terms it was below long run averages and in nominal terms well below average. One idea that was getting greater credence was what they termed ‘Helicopter Money’. The state would raise debt and hand the proceeds out to taxpayers. The idea seemed in some ways farfetched and there was worry about what it would do to inflation. But by the close of 2019 we were getting close to some countries trying it. What the pandemic has done is put that into motion. The fiscal transfers that we are going through at the moment is larger than the lost income due to shutdowns. The Helicopter is spinning around us.
We have not seen the full impact of this yet because the service side of the economy has not be able to function. Goods consumption is now well ahead of where it was pre-pandemic so when we get the service side re-opening there is likely to be a large spurt in activity. From what we have seen of the policy thus far it does seem to boost aggregate demand which was viewed as the weakness in the past cycle.
And the growth contributors could broaden
Confidence about aggregate demand is the major driver of capital investment. If corporates believe that sales can grow, then they will invest. With interest rates at zero or less the breakeven for any capital investment project is low. Thus as 2021 progresses we could see capital investment start to contribute more and give further momentum to the economy.
For the past number of months, we have had the same story across the global economy. Short term disruption that is not as bad as expected and forecasts being increased. More policy measures are being announced and implemented that will give a big economic bang when we re-open fully.
And it is generating powerful earnings growth
What has come to light over the last number of weeks, as we travelled through the Q4 reporting season, is how effectively companies are turning economic activity into earnings growth. In the US the S&P is reporting earnings growth on a year-on-year basis and that is off Q4 2019 which was not a recessionary quarter. In the euro area it is down but only slightly. Certain industries are seeing big drops (Energy; Travel; Leisure; Aerospace) and if we exclude these the S&P is reporting earnings growth of 12% year-on-year. For the amount of economic activity that we had in Q4 2020 that is an extraordinary out-turn. It appears we are on the cusp of a very strong profit cycle.
Mindful of risks
As we pointed out last month the major risk that we see is an inflation scare that destabilises the bond market. There have been no developments over the last month to change our view on this. While we believe economic growth will be strong there are also anti-inflationary pressures which should keep prices in check. Fixed income markets are under modest pressure, but it is contained and the backstop of Central Banks remains effective. We are watching developments here closely.
What are we thinking about?
Equities remain our favoured asset class and we still believe in the reopening theme. A couple of things have come up over the last few weeks. The new energy theme got a lot of focus last year and it became quite a heated part of the equity market. There have been sizeable corrections in some of these companies over the last month and we are looking to see if there are opportunities being created. The other area that we are looking at is the US bond market. The yield gap over euro area bonds has moved onto an attractive area even on a hedged basis.