“As corporate profits are rising much faster than expected, high valuations in the equity market are falling fast. Equities therefore remain attractive,” said Natasha Ebtehadj, global equities portfolio manager at Columbia Threadneedle, in a recent conversation with Fondsnieuws, Investment Officer Luxembourg’s sister publication.
“While the economy is still weighed down by Covid-19, worldwide records are being broken on the stock markets. The stock market boom seems illogical, as the end of the pandemic is not yet in sight. You see investors struggling with this and wondering if the markets are not reaching a ceiling,” said Ebtehadj.
However, she said that she believes the rally is based on sound fundamentals, because corporate earnings growth is so strong. This is especially the case in the US, which makes up about 60 per cent of the MSCI World Index. “Profits of US companies have exceeded expectations by a wide margin for five quarters in a row and are well above 2019 levels. Results in most other countries have also rebounded strongly to pre-Covid heights.”
Equities not expensive
The good earnings momentum justifies the high valuations, Ebtehadj argued. “Last year around this time, equities were priced solidly and the earnings outlook was very uncertain. Thanks to the positive earnings surprises, price-to-earnings ratios have fallen, supporting the stock market.” She is also encouraged by the fact that analysts are significantly raising their earnings estimates for this year but lowering them for 2022. “The consensus for 2021 is earnings per share growth of 46 per cent for global equities and only 8 per cent for 2022. This leaves room for positive earnings surprises next year as well.”
From this point of view, Ebtehadj said that she is unworried about the relatively high valuations in the stock market. Global equities are trading at less than 20 times expected earnings for the next 12 months and are therefore not very expensive. Certainly compared to fixed-income securities. German government bond yields are still negative and risk spreads on corporate bonds are historically very low. Shares therefore remain relatively attractive.
Crucially, she said, corporate earnings growth will continue. The number of positive earnings surprises peaked this year and will logically decline, also in light of the continued rise of the delta variant of Covid-19 and weakening global economic growth. But the consensus for next year seems to be perfectly attainable. If profits continue to rise, equity markets could also move higher.
Tencent sold
Ebtehadj warns of a possible rise in the risk premium, however. Investors are likely to pay less for equities if the economic outlook worsens because of the pandemic or if interest rates rise more than expected. In addition, China’s tough stance on the technology sector could cause a market correction, the fund manager said. For this reason, Columbia Threadneedle recently sold its position in Tencent, after the shares had been part of the asset manager’s flagship Threadneedle (Lux) Global Focus fund and other equity portfolios for years.
“The education sector in China is no longer allowed to make a profit and we expect other sectors to face more regulation as well. Although it is too early to conclude that the Chinese stock market will become inelegant, companies will have to adapt to the new policy regime. For many companies, it is not clear what the earnings profiles will look like in three to five years’ time.”
The Threadneedle Global Focus fund is currently overweight large technology, healthcare and consumer companies in the US and other developed countries. The three largest positions are Microsoft (7.9 per cent), Alphabet (6.1 per cent) and Amazon (5.9 per cent). Lesser-known names such as the US accounting software producer Intuit and the Japanese medical concern Hoya are also part of the portfolio. The focus on sustainable growth companies has paid off: since its launch in mid-2016, returns have averaged 18.4 per cent a year, compared to 13.8 per cent for the MSCI ACWI index.
“We focus mainly on quality companies with a strong competitive advantage, which show consistent earnings growth through the economic cycle. This positions us well in an environment characterised by uncertainty around the pandemic and central banks’ monetary policy,” Ebtehadj said.