Global perspectives: Moving to a cautious outlook
We move to a cautious outlook on global equities. During September we are continuing to see risk factors build while equity valuations remain at extraordinarily high levels.
We believe portfolio managers will face monetary and fiscal headwinds in 2022, in addition to a progressive slowing in economic momentum. Furthermore, inflation in developed markets has been higher than our earlier expectations and inflation uncertainty in survey data continues to increase. The combination of a slowdown in growth and an inflation problem coming to a head could represent a challenge to equity market progress in coming months.
In some respects, the policy measures to combat the negative effects of COVID-19 have become almost overly successful in developed markets. Risk assets have rallied strongly as output gaps rapidly close. Few would have expected that in a post-COVID world global 2021 earnings estimates would be above those prevailing before the pandemic.
Nevertheless, we believe it is the rate of change of the economic outlook which drives markets and as momentum slows there are in our view both qualitative and quantitative arguments which would suggest investors should tactically lean against the prevailing positive market sentiment at this time.
The economic recovery from COVID-19 in developed markets has been rapid during 2021, aided by each of fiscal policy, monetary policy and the quick development and distribution of vaccines. In the UK, and in the continued absence of a COVID-19 variant yet more infectious than ‘delta’, vaccines have kept hospital admissions to below the critical levels which trigger social restrictions. Furthermore, a significant degree of naturally acquired immunity amongst younger adults now offers additional protection from a surge in cases later in the year.
As a result of the success of vaccines, the ‘rate of change’ of stimulus measures is either now negative, such as the recent direction of developed market monetary policy, or pending a decline as is the case for COVID-related fiscal stimulus measures from 2022 onwards.
While global earnings estimates for 2021 have provided a strong tailwind for markets in 2021 this impetus is now fading as earnings forecasts have risen to beyond those prevailing prior to the pandemic. We note that over the past month earnings forecasts have stopped rising for the majority of global sectors.
In addition, manufacturing PMI indices appear to have peaked over the summer, although they are still at levels which are indicative of strong growth in developed markets. We also note the declines in iron ore pricing and the below-50 manufacturing PMI readings in China which both signal a contraction is underway.
In terms of valuations, the median forward price/book multiple is at 15-year high on a global basis. We have added an additional parameter which is our estimate of the global equity risk premium which was stable at 3% prior to the pandemic but is now also close to a 15-year low of 2.25%. Corporate credit spreads are also making lows not seen since 2004.
The key risk to the outlook in our view is no longer the evolution of COVID-19 but the evolution of inflation. Implied market-based measures of inflation would appear to show little cause for concern but we would also argue pricing is to a large extent supressed by investors’ focus on central banks’ asset purchases in recent years. Consumers, and particularly lower-income consumers, believe a significant increase in inflation lies ahead in coming years.
A rise in inflation uncertainty is an unwelcome development as it may create monetary policymaking uncertainty and historically has been associated with significantly lower market valuation multiples than prevail today.
We therefore take the opportunity to move to a cautious position on global equities, notwithstanding the modest declines over the past few weeks and the still-positive current economic conditions. We believe tactically shifting allocations to lower risk assets and adding cash allocations to portfolios, emphasising capital preservation rather than returns is prudent for the short-term, given slowing economic momentum. The risks to our view include a re-acceleration in growth and a signal from China that the state will absorb the losses from any spill-over from the ongoing defaults in the property sector, or reverse course on its new initiative to regulate China’s technology sector.