In the August issue, we look at why bond and equity markets currently reflect different views of global growth.
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The equity and bond markets appear split on the global growth outlook. The MSCI All Country World equity index has rallied 11% (GBP, total return terms) this year on the back of a global growth recovery and accommodative policy support1. In contrast, the US 10-year Treasury yield has trended down since the end of March. As a rule of thumb, lower government bond yields generally reflect weakening economic activity and vice versa. Clearly, both markets can’t be right on the economic outlook.
Although volatile, the equity market appears relatively upbeat on future company earnings. The consensus currently forecasts historically high one-year forward global Earnings Per Share growth of 19%, albeit down from a cyclical peak of 27% in June2. As we discussed in the July Investment Outlook, private consumption, the driving force for the GDP expansion and company earnings, remains underpinned by healthy finances. Reopening from lockdowns adds another layer of support for the consumer expansion. For instance, by removing remaining social distancing laws in England on 19 July, sectors such as leisure and hospitality will be able to boost operations and revenues.
Aside from consumption, supply shortages brought about by the pandemic are stimulating a new capital expenditure cycle. As a lead indicator of company investment, the Business Roundtable US Chief Executive Officers survey on capital spending plans rebounded to its highest level in nearly two years in the second quarter3. Provided demand can be sustained, there is a solid base for companies to deliver on markets’ earning expectations, the fundamental driver of equity prices.
For the bond market, it is possible that yields have been anchored down by technical factors related to money flows into the US bond market (the world’s largest), rather than a deterioration in underlying growth. For instance, Treasury demand has been supported by international investors adding to positions following record redemptions during the pandemic, while bond supply has been squeezed by the Fed effectively buying up all new Treasury bond issuance during the second quarter. That’s been possible as the US government has run down cash balances raised during record bond sales last year for fiscal spending. Bond yields have also been lowered by a Fed that is intent on keeping policy accommodative. In short, prevailing market bond yields may convey an overly pessimistic economic outlook.
Market risks to watch over the summer
Despite the relative upbeat macro backdrop above, we identify three drivers to monitor as potential sources of asset price volatility during the summer months.
1. Elevated inflation: Consumer price inflation has increased globally, and particularly in the US, where June underlying core (ex-food/energy) inflation accelerated to a 4.5% annual rate, its fastest clip for 30 years4. Higher inflation could feed through to equities via multiple channels. First, the rising cost of living has encouraged workers to demand higher wages, adding uncertainty over company profit margins. Second, if goods and service prices become increasingly unaffordable it could depress growth through “demand destruction”. And third, central bankers may surprise markets by reining back on accommodative policy.
In July, Bank of England Monetary Policy Committee member Michael Saunders warned that if activity and inflation indicators remain in line with recent trends and downside risks do not rise significantly, “then it may become appropriate fairly soon to withdraw some of the current monetary stimulus.” Given equities have been boosted by the easy money policy, taking the liquidity punchbowl away could unsettle markets.
2. Covid mutations: With just over 14% of the world population fully vaccinated, Covid is likely to remain an ongoing market risk5. The rise in the more infectious Delta variant has led some governments to implement consumer restrictions, such as excluding the unvaccinated from bars, restaurants and shopping centres in France from August and spectators at the Tokyo Olympics. Moreover, the UK government’s Test and Trace app has led to increasing numbers of people being ordered to self-isolate, which can disrupt economic activity in a so-called “pingdemic”. Nevertheless, given that the UK Office for National Statistics reports that an estimated 90% of the adult population have tested positive for coronavirus antibodies in England, the vaccine rollout and herd immunity is proving so far to be fairly effective in breaking the link between infections and deaths/hospitalizations6.
3. Peaking economic growth: The global All Industry Purchasing Managers Index (PMI), a broad-based proxy of growth that include manufacturing and services, peaked in May and has raised uncertainty over the growth outlook. However, we found that global equities generally produce positive forward returns when the global growth rate peaks. For instance, during the last two business cycle peaks, in April 2010 (after the Global Financial Crisis) and in January 2004 (after the dot.com bubble), forward four-year annualised global equity returns were 12% and 11%, respectively7. Though when growth slowed from a dot.com bubble peak in April 2000, the four-year annualised equity returns were -5%, largely because the global Price-to-Earnings (PE) valuation of 22.8 times was high at the time8. Global equities are less demanding than during the dot.com era and currently trade on a PE of 18.7 times9.
To sum up, with bond yields low, equities still look an attractive place to generate returns in the current growth outlook. However, risks have risen, and this could lead to rising market volatility.
1-9 Refinitiv Datastream/Smith & Williamson, ONS, data as at 28 July 2021
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.