Real yields have surged and inflation expectations have fallen, posing the most significant challenge to equities since the pandemic sell-off almost a year ago.
Should investors worry? To the degree that higher yields represent more economic growth, this should boost corporate profits and so equities. We think the rise in yields does not reflect the market anticipating some monetary tightening by the US Federal Reserve to forestall inflation. For that, it is too early in the recovery. The unemployment rate would have to fall and wages rise significantly, with an accompanying and sustained increase in inflation, before the Fed would consider any tightening.
And what about the drop in inflation expectations? We expect it not to last. With the US administration’s stimulus package advancing through Congress and the expected surge in demand meeting limited capacity, expectations for higher prices should resume soon.
What is happening to growth? More infectious virus mutations and delayed vaccine rollouts have pushed back the likely date when lockdown restrictions are expected to be lifted. In countries where the curbs have been reduced, activity has remained subdued. The pace of immunisations should accelerate in coming months. A bigger concern might be the slow pace in emerging markets, which could delay the resumption in activity that markets expect in the second half of the year.
That said, US activity is now twice the level of that in the UK and two-thirds higher than in Germany. This is reflected in the data: US purchasing manager indices are near 60 compared to sub-50 readings for much of Europe. Retail sales growth in the UK has plunged to -3.8%, while it has soared to 6.1% in the US thanks to government stimulus cheques and the prospect of more.
Higher activity has left US real GDP only 2% below pre-pandemic levels, which is prompting the surge in bond yields. The volatility we saw recently in equities and bond yields reflects a transition from liquidity-driven markets anchored by low real yields to growth-driven markets where earnings per share growth will drive equities.
To date, reports on fourth-quarter 2020 earnings have turned out better than expected. With 491 S&P 500 companies having reported, earnings have risen by 3.9% from 2019 levels with earnings surprises at 17%. European companies have done nearly as well, with 3.1% earnings growth rather than the 14% fall that analysts had expected.
As a result, estimates of forward earnings have risen, particularly for the US tech sector. This increase in earnings expectations has kept pace with the rise of the index, meaning the forward price/earnings (P/E) has remained unchanged at 22.6x. For earnings estimates to continue to be revised up, the full USD 1.9 trillion package proposed by the Biden administration will need to be passed and/or activity needs to rebound more quickly if the pace of vaccinations allows it.
Revisions for Europe have not lagged significantly behind those for the US, although multiples have been compressed slightly. While Europe has far less fiscal stimulus to look forward to, the comparatively low level of economic activity means the rebound should be greater once a higher share of the population has been inoculated.
Vaccination rates in emerging markets are lower than in Europe, but as most countries have imposed far fewer restrictions and many adults are not able to work from home, activity has already started to recover.
In the current interest-rate environment, it is not surprising investors anticipate higher total returns from equities than from bonds. Commensurately, they have allocated more funds to equities. Given the gap between equity earnings yields and real bond yields, we believe this allocation is appropriate. We estimate the difference in yields to be 6.4%, which is 160bp above average.
This is an extract from our asset allocation monthly for March – read the full document here
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.