Macro policy means we have fiscal spending largesse, ultra-easy monetary policy and enormous piles of debt, which are creating the conditions for excesses. We expect continued strong market performance in the shorter term, before a bumpier ride. For investors, looking ahead is crucial - the leaders during the pandemic won’t necessarily be the winners over the next period. Strictly defining and uncovering sustainable earnings growth is the best way for investors to protect against risks.
A cognitively dissonant market
Psychologists define cognitive dissonance as holding conflicting ideas at the same time. The market that we have experienced over the past year seems to fit the description.
Since the market lows triggered by the Covid pandemic in March 2020, returns for risk assets have been stellar. It’s not only the equity market that is behaving in this peculiar way, the economy is too. We are seeing growth in income per capita in major economies, starting with the US, and climbing house prices in the same countries.
To simultaneously process the worst recession since World War II, growing wealth and a dazzling equity bull run requires some mental acrobatics. It’s easy to dismiss the latter as market exuberance or even a bubble, but the reality shows that there is a powerful earnings recovery underway. And where earnings are expected to go, the market follows.
Surging earnings ahead
Fiscal spending and supportive monetary policies have not only provided a cushion for corporate revenues and household wealth, but also a bounce. Consumers, forced to hoard wealth as they have limited spending choices, currently have historically high savings rates, and, as lockdowns ease, the release of just some of these savings should underpin a strong recovery. With those conditions in place, we can reconcile our fundamental analysis that says earnings are surging higher with record levels in the stock market.
For 2021, our analysts, based on bottom-up, aggregate data, anticipate at least 32% growth in global earnings per share compared to 2020 and 14.2% versus 2019. Asia should lead the regions in a case of ‘first-in, first-out’ of the pandemic. Even sluggish Europe should post higher earnings than in 2019, and only two sectors (energy and industrials), out of eleven, are expected to be less profitable than 2019.
The debt hangover
States have deep pockets and when they launched the biggest fiscal spending programmes in history it had a substantial impact, but these kinds of policies can only work over the short term. As the effects of fiscal intervention dissipate over the longer term, the outlook will become cloudier. At best we may have declining growth; at worst we could see the bull market derailed.
Fiscal largesse has piled more debt onto the system, and we could face some sort of bust - a period of rapidly slowing growth - but it would be limited given that central banks are incentivised to preserve low interest rates in order to keep the mountain of debt manageable. The alphabet soup of ZIRP (zero interest rate policy), TINA (there is no alternative) and FOMO (fear of missing out), and the Fed Put are here to stay.
In the long run, debt is a drag on profitability and there is a strong negative correlation between the level of national debt and return on equity. With long-term growth falling in major economies reflecting the challenges of growing the active population and eking out productivity gains, the struggle is uphill.
This scenario is not so much like the 1930s when the bust was deep and prolonged, but more like the 1870-80s when the crisis occurred against a backdrop of disruptive innovation, protectionism and a halt in migration. In the 1870s, the second industrial revolution was underway, countries reacted to the economic collapse with protectionist measures and migration slowed culminating in the US’s Chinese Exclusion Act of 1882. Today, digitisation is disrupting traditional businesses, trade wars are reversing globalisation and Covid-19 has frozen migration.
Abundant liquidity could lead to bubbles
What’s different today however, is that liquidity is far more abundant. Reacting to the crisis in the 1870s, the US government vetoed legislation that would have injected monetary stimulus until eventually, some years later, Congress bypassed the White House. At the same time in the UK, the Bank of England kept interest rates as high as 9%. Contrast this with 2020, when central banks swiftly unleashed waves of money supply and cut rates to the floor.
With liquidity plentiful and a strong cyclical rebound taking hold, higher real interest rates are not an option as they could choke off the recovery. The balance of risks for equities is therefore to the upside, however, it won’t be a smooth ride. If central banks don’t fight higher inflation there will be volatility and the potential for asset bubbles.
New Zealand seems to be the first authority to start countering bubbles following the beginning of the pandemic. It recently added house price stability to its list of central bank targets following a near 20% rise in property prices in the 12 months to January 2021.
Stock markets are not clear of frothiness either. It’s true that there is little income and expected capital appreciation available elsewhere, for example in bonds, and as a result, we can expect steady inflows into equities, but frenzies such as the one around SPACs are not sustainable. Many of these vehicles are already trading lower than their IPO prices.
Potential black swan risks are all around
We should also remember that we are not clear of Covid-19 and may not be for some years. Vaccines are helping to stop its spread, but with less than 2% of the global population fully vaccinated as of the end of March 2021 according to the WHO, we could experience more outbreaks. So even if we are better equipped to deal with infections than we were at the start of the pandemic, it doesn’t mean we can resume normality. Ongoing disruption is here to stay for some time.
With a range of risks facing investors, we will have to remain active and nimble. We cannot revert to what’s worked pre-pandemic or even during the pandemic. The GAFAM (Google, Amazon, Facebook, Apple, Microsoft) companies led over these periods but that doesn’t mean they will be the winners over the next period. We are recovering from the pandemic, macroeconomic policy is shifting, and data points are changing - investment solutions won’t come from looking backwards.
In an investing climate full of cognitive dissonance, we should stick to the primacy of earnings to dictate returns over the long term. Strictly defining and uncovering sustainable earnings growth is the best way for investors to protect against risks.
EQUITIES BLOG: Stick to sustainable earnings for the bumpy ride ahead (fidelity.be)
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