What a start | Top Down

We are not yet four months into the year and already equity markets have delivered double digit returns in Euro terms. This is despite the lockdowns still in place across many parts of the world and still causing disruption to societies and economies. Of course, the roll out of vaccination programmes meant this disruption would be temporary and that the fiscal support that had been put in place would lead to a very strong recovery once economies started to re-open. Hence equity markets could look through the temporary disruption and focus on the upcoming recovery and return towards normality. It is not surprising that equity markets are up, it is the scale of appreciation that has taken people by surprise and made them wonder whether they are due a correction.

There are reasons behind this strength 

But there have been surprises this year that would justify a better outcome from equity markets. Firstly, we had an early agreement to a fiscal package in the US at the start of the year. Then we had a further unexpected fiscal package agreed in March. We had the conclusion of the US election providing a Democratic (pro-spending) sweep. As a result, there have been significant upgrades to the consensus forecast for economic growth. At the start of the year the US was expected to grow by just over 4% in 2021, that figure now stands at over 6% and is likely to go higher. We believed forecasts were too low at the start of the year, but we did not expect them to be rising towards 7%.

This change has been enough to move the forecast for global growth from 5.2% in 2021, to 5.6%. We expected a very good 2021 for the global economy but it is shaping up to be an excellent one. The possibility of some of President Biden’s ‘Build Back Better’ plan being implemented means that there will be further fiscal support going into 2022. Again, not an outcome we would have expected at the start of the year.

And this is producing exceptionally strong profit growth

As with the economic forecasts the earnings expectations have been rising also, an unusual event. Normally we start the year being too optimistic and reduce the forecast as we travel through the year. But in 2021 the consensus forecast for global earnings growth has risen from 25% at the start of the year to 29% now. We have just started the Q1 reporting season and the forecasts look like they will have to rise again. Earnings growth looks like it will be 5 to 10 percentage points higher in 2021 than we thought at the start of the year.

And the profit base is higher

Over the last few months, we have found out what 2020 was actually like for corporates. When the recession began 12 months ago people thought that global earnings would be down anywhere between 20% and 30%. That figure looks like it is going to finish up somewhere between 10% and 11%, a mild profit recession. So, we have not only stronger earnings growth but a higher base from which that growth is coming from. Little wonder equity markets have been very strong.

And Central Banks are not budging

Despite the much stronger growth outlook and the additional fiscal stimulus Central Banks have maintained the same policy line. The ECB increased its QE programme and the Fed reiterated that it will move interest rates only when inflation has actually risen on a sustained basis The timeline for interest rate increases has not changed year-to-date. It still looks like a late 2022/2023 story. Accelerating growth and no change to monetary policy is a powerful combination for equity markets.

And bond markets have not been too bad

Bond market returns for the year are negative, about -2% in the euro area. Given that we started with negative yields it was always going to be difficult to achieve a positive return. The better economic growth and further fiscal stimulus in the opening months of the year meant the environment was not going to be bond friendly. However, the price action has been quite orderly and recently we have seen some stability return to the bond markets with prices grinding up modestly from the lows. The Central Banks backstop is proving very effective.

What should you do?

After strong moves in equity markets it is tempting to think about taking some profit. However, we would caution against such action. Firstly, the strength in equity markets may have surprised people but then equity markets have been surprised by the level of additional stimulus that is going to be deployed. Secondly, our starting point is higher, economic activity and corporate profits have held up better than expected. Thirdly, none of this has led the Central Banks to change their policy line. Lastly, we are only moving into the second year of the cycle and equity markets trend upwards until the cycle ends. Thus, you are left with a tactical decision, can I sell now and buy back lower down. For that to add any value then we must have a 10%+ correction in equity markets. Given that we are going to have strong data over the next couple months, both economic and corporate, and that some order is coming to the bond markets it is difficult to see that level of correction in the short term.

What are we doing?

At an asset level we are holding our overweight position in equities. We do not see much chance of adding value by being tactical at these levels. We will be looking to adjust our equity exposure as we move from the early part of the recovery phase. We have been doing some of this by reducing some of our Industrial exposure. Emerging Markets, which benefit disproportionally from strong global growth lagged the world this year and we increased our exposure there. We are holding our Consumer Cyclical exposure as the next leg of the recovery is likely to be consumer led as economies re-open. In the fixed income world, the correction in the US bond market allowed us to add exposure there on a positive yield after hedging costs. We would like to do more of that.

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