Q2 2021 GLOBAL EQUITY COMMENTARY
Sidebar: The COVID-19 pandemic appears to be entering a new and more viral phase. The good news is that there is an increasing volume of vaccines being rolled out, and businesses are gradually resuming normal operations. Strong global economic growth, surging corporate profits, and elevated investor confidence have helped to extend the bull market and boost global equities to record highs.
Global economy buoyed by positive vaccine efforts
Vaccines have now reached close to half the population in many developed countries and are increasingly gaining traction in other nations around the world. As economies gradually reopen, considerable pent-up consumer and business demand is being unleashed and permanent scarring from the pandemic, so far, appears to be limited. Our business-cycle model continues to situate the global economy in the “expansion” stage and suggests further room for gains, although we note that the cycle is moving more quickly than normal. We remain optimistic about the trajectory of the global economy and anticipate rapid growth in 2021, followed by slower, but still solid growth in 2022. That said, a significant rise in market expectations tempers our enthusiasm somewhat as heightened investor expectations are becoming more difficult to surpass.
Risks to our positive outlook
A variety of risks may challenge our positive base-case scenario. The extremely contagious Indian “Delta” variant of the virus could prompt further waves of infection similar to how the emergence of the highly contagious British variant contributed to a surge in the spring. Moreover, there is a risk of a fiscal hangover in 2022 as some spending initiatives expire, and the possibility exists that investor confidence will wane if central banks contemplate withdrawing monetary stimulus. Another key risk is that inflation has spiked higher. While we believe much of the increase is temporary, a period of sustained higher inflation would erode purchasing power, increase borrowing costs, and encourage central banks to be more hawkish.
Inflation accelerates as price pressures mount
Higher commodity prices and factors such as shortages of shipping containers and computer chips are contributing to rising inflation, which is now accelerating in several countries. We expect elevated inflation over the next several months, moving to moderately above the long-term averages over the next few years.U ltimately we antcipate average or even slightly below average inflation over the longer term. Stimulus cheques have prompted many Americans to spend on big-ticket goods such as cars and houses, pushing prices higher. But demand preferences should revert, at least partially, to historical norms as the impact of the pandemic fades. There are, however, several scenarios that could lead to an unwelcome period of relatively high inflation. Rising inflation expectations could become a self-fulfilling prophecy, a wage-price spiral could unfold, and/or a commodity super cycle could emerge. Inflation, an afterthought for the past decade, we believe now requires some attention.
U.S. dollar bear market to persist
We think the U.S.-dollar bear market that began last year still has a few years to run. Currencies often move in cycles, from overvalued to undervalued, and the dollar remains rich even with the weakness of the past year. The stimulative fiscal and monetary policies pursued by the U.S. we believe will continue to support the weakening trend. While the early stages of a bear market in the greenback will benefit all currencies, it is cyclical currencies, including the Canadian dollar, that have the most to gain from the global economic recovery underway. Broadly speaking, emerging-market currencies should also rally, although careful monitoring of country-specific risks is necessary to avoid individual currency underperformance.
Stocks rally to record levels on surging profits
Global equities extended their gains in the past quarter with most major indexes reaching record levels. The solid rally in stocks has pushed many equity-market valuations to their highest levels since before the 2008/2009 financial crisis. While the S&P 500 and other leading iIndexes may currently appear expensive, they could grow into those elevated valuations quickly as a surging global economy boosts volumes and pricing power, lifting revenues and earnings, and leading to a durable earnings expansion that could last several years. Analysts are quickly picking up on the fact that profits are rebounding quickly and earnings-per-share estimates for the S&P 500 have increased nearly 10% since the start of the year. Our conclusion is that U.S. stocks could offer decent returns in the mid to high single digits if investor confidence holds up and earnings come through. Return potential improves as we move outside of North America to regions such as Europe, Japan, and emerging markets, all of which offer more attractive valuations and potential for upside in returns.
Q2 2021 GLOBAL EQUITY COMMENTARY
Global economy buoyed by positive vaccine efforts
Vaccines have now reached close to half the population in many developed countries and are increasingly gaining traction in other nations around the world. As economies gradually reopen, considerable pent-up consumer and business demand is being unleashed and permanent scarring from the pandemic, so far, appears to be limited. Our business-cycle model continues to situate the global economy in the “expansion” stage and suggests further room for gains, although we note that the cycle is moving more quickly than normal. We remain optimistic about the trajectory of the global economy and anticipate rapid growth in 2021, followed by slower, but still solid growth in 2022. That said, a significant rise in market expectations tempers our enthusiasm somewhat as heightened investor expectations are becoming more difficult to surpass.
Risks to our positive outlook
A variety of risks may challenge our positive base-case scenario. The extremely contagious Indian “Delta” variant of the virus could prompt further waves of infection similar to how the emergence of the highly contagious British variant contributed to a surge in the spring. Moreover, there is a risk of a fiscal hangover in 2022 as some spending initiatives expire, and the possibility exists that investor confidence will wane if central banks contemplate withdrawing monetary stimulus. Another key risk is that inflation has spiked higher. While we believe much of the increase is temporary, a period of sustained higher inflation would erode purchasing power, increase borrowing costs, and encourage central banks to be more hawkish.
Inflation accelerates as price pressures mount
Higher commodity prices and factors such as shortages of shipping containers and computer chips are contributing to rising inflation, which is now accelerating in several countries. We expect elevated inflation over the next several months, moving to moderately above the long-term averages over the next few years.U ltimately we antcipate average or even slightly below average inflation over the longer term. Stimulus cheques have prompted many Americans to spend on big-ticket goods such as cars and houses, pushing prices higher. But demand preferences should revert, at least partially, to historical norms as the impact of the pandemic fades. There are, however, several scenarios that could lead to an unwelcome period of relatively high inflation. Rising inflation expectations could become a self-fulfilling prophecy, a wage-price spiral could unfold, and/or a commodity super cycle could emerge. Inflation, an afterthought for the past decade, we believe now requires some attention.
U.S. dollar bear market to persist
We think the U.S.-dollar bear market that began last year still has a few years to run. Currencies often move in cycles, from overvalued to undervalued, and the dollar remains rich even with the weakness of the past year. The stimulative fiscal and monetary policies pursued by the U.S. we believe will continue to support the weakening trend. While the early stages of a bear market in the greenback will benefit all currencies, it is cyclical currencies, including the Canadian dollar, that have the most to gain from the global economic recovery underway. Broadly speaking, emerging-market currencies should also rally, although careful monitoring of country-specific risks is necessary to avoid individual currency underperformance.
Stocks rally to record levels on surging profits
Global equities extended their gains in the past quarter with most major indexes reaching record levels. The solid rally in stocks has pushed many equity-market valuations to their highest levels since before the 2008/2009 financial crisis. While the S&P 500 and other leading iIndexes may currently appear expensive, they could grow into those elevated valuations quickly as a surging global economy boosts volumes and pricing power, lifting revenues and earnings, and leading to a durable earnings expansion that could last several years. Analysts are quickly picking up on the fact that profits are rebounding quickly and earnings-per-share estimates for the S&P 500 have increased nearly 10% since the start of the year. Our conclusion is that U.S. stocks could offer decent returns in the mid to high single digits if investor confidence holds up and earnings come through. Return potential improves as we move outside of North America to regions such as Europe, Japan, and emerging markets, all of which offer more attractive valuations and potential for upside in returns.
Data source: Morningstar, 1 April 2021 to 30 June 2021. Past performance is no guarantee of future results. Indexes are unmanaged and unavailable for direct investment.
Data source: Morningstar, 1 April 2021 to 30 June 2021. Past performance is no guarantee of future results. Representative indexes: Large Cap: Russell 1000 Growth Index and Russell 1000 Value Index; Midcap: Russell Midcap Growth Index and Russell Midcap Value Index; Small Cap: Russell 2000 Growth Index and Russell 2000 Value Index. Indexes are unmanaged and unavailable for direct investment.
Data source: Morningstar, 1 April 2021 to 30 June 2021. Past performance is no guarantee of future results. Data is based on GICS sectors from the S&P 500 Index. Chart shows the three top and bottom performing sectors. Indexes are unmanaged and unavailable for direct investment.
Data source: Morningstar, 1 April 2021 to 30 June 2021. Past performance is no guarantee of future results. Representative indexes: China: Shanghai Stock Exchange Composite; Emerging Markets: MSCI Emerging Markets Index; Europe/Australasia/ Far East: MSCI EAFE; Europe: Euro Stoxx 50 Index; Germany: DAX Index; Hong Kong: Hong Kong Hang Seng Index; Japan: Nikkei 225 Index; United Kingdom: FTSE 100 Index; MSCI World ex-U.S. Index. Indexes are unmanaged and unavailable for direct investment.
U.S: Re-opening and the consumer driving strong economic recovery
The state of play regarding the pandemic in much of the U.S. is decidedly positive. The vaccine rollout, one of the world’s most successful, has largely halted the spread of COVID-19, so far. The number of new daily cases is down 67% from the mid-April peak and the strain on the hospital system has eased substantially. At the height of the rollout, the U.S. was inoculating roughly 3.5 million people per day, and by early June will have administered over 300 million doses. More than 50% of all U.S. adults are already fully vaccinated, and the Biden Administration’s goal is to have over 75% of adults receive at least one dose by July 4. Many states have removed all restrictions regarding masks and social distancing, and most of the rest are rapidly moving toward a full re-opening before the end ofsometime in June. As a result, personal mobility has improved: road traffic has rebounded; the malls are busy; hotel occupancy is up; more people are flying and taking public transit; and, in the states that are fully open, restaurant reservations are back to pre-COVID levels. Finally, the virus no longer seems to have the upper hand, at least for the moment, leading to continued gains for stocks.
The response of U.S. monetary and fiscal authorities to the coronavirus crisis was and continues to be extraordinary. Since the pandemic was declared a year ago, the U.S. Federal Reserve (Fed) has injected about US$6 trillion including loan guarantees into the financial system, while Congress has passed stimulus bills totaling US$5 trillion. As the economy rebounds, and employment and inflation pick up, we expect the Fed to gradually begin tightening monetary policy sometime next year. On the fiscal side, the Biden Administration has proposed two bills worth about US$4 trillion in new spending: the American Jobs Plan focused on infrastructure, broadband access, the electric grid, and climate change; and the American Family Plan, which considers education, health care and social inequality. As proposed, the jobs plan would be partially financed by increasing corporate taxes, while the boost to social services would derive its funding partially from increased taxes on high-income individuals. We believe, converting these bills into law, as proposed, is a long shot. While there is bipartisan agreement on the need for spending on infrastructure, there is no agreement on how to pay for it. Our best guess is that a substantial infrastructure bill will be passed into law this fall, while many of the other priorities will be delayed.
The U.S. economy is mainly driven by household spending, which is at its strongest levels in 40 years amid huge increases in housing wealth and almost US$2 trillion in additional savings accumulated during the pandemic. As the re-opening proceeds, the increased mobility should drive improvedncreased economic activity and demand for labor, lifting consumer confidence, while leading to even more economic activity and job creation. We anticipate this positive feedback loop should last well into 2022 and supports the cyclical orientation in our investment portfolios. Many companies have noted rising cost pressures due to increasing prices for raw materials such as steel and lumber, as well as prices for shipping. We expect these price increases to be temporary, as they start to attract competition and supply increases. In addition, the shift from spending on “things” to spending on services ought to ease supply-chain pressures and put a cap on prices for goods.
The S&P 500 remains expensive at a price-to-earnings multiple of 21 times the consensus 12-month earnings estimate of US$198, compared with a trailing five-year average of 18. It seems clear to us that valuations are likely to remain high until macroeconomic risks start to creep back. Potential sources of risk include a significant rise in interest rates, increased regulations and taxes, disappointment in Congress’s efforts to pass an infrastructure bill and the unchecked spread of COVID-19 variants. Of these risks, we think tighter regulation and higher taxes seem highly likely sometime in the next 12 months.
CHINA: Growth recovery to continue
Asia’s economic recovery has been strong, albeit uneven. China and South Korea have continued to outperform the rest of the regionof region. In China, we expect the growth recovery to continue, and for Beijing to likely withdraw some of its economic stimulus in the coming months. However, significant changes in policy are unlikely in our view. The economy surged year over year in the second quarter. Growth in exports, industrial production and retail sales all beat consensus expectations, while growth in fixed-asset investment was weaker than expected. Chinese GDP growth is forecast at 8.8% for this calendar year.
China has set relatively conservative growth targets, prioritizing the management of excess leverage with the aim of bringing credit growth in line with nominal GDP. The tightening bias is also reflected in a continuing squeeze of residential property, with limits on developers’ financial ratios and real estate lending. China’s tightening bias is leading to strong support for Chinese bonds, which have attracted substantial foreign capital, and this relatively conservative policy stance suggests long-term renminbi currency appreciation.
From an investment perspective, a key change we see in the composition of the MSCI China Index is the increased importance of internet-related companies, which now comprise about 50% of the index’s market capitalization, surpassing the historic dominance of Financials, Energy and Materials. The surge in the valuation gap, between internet stocks and slower-growth sectors, has resulted in an acceleration in this weighting difference. We remain optimistic about the outlook for Chinese equities but are keeping a close eye on the shift away from highly valued growth sectors since the fourth quarter of 2020.
EUROPE: Vaccinations are key
European markets have been robust since late February, as leading economic indicators are also showing strength, and GDP growth is expected to peak at some stage in the third quarter of this year. Earnings expectations are rising globally, offering solid support to Europe’s equity markets.
The key concern for investors, over the past year, has obviously been the effectiveness of attempts to get the coronavirus under control. While the timing and extent of lockdowns has varied somewhat across the region, all countries have had success in containing the spread of COVID-19. Vaccinations offer the next leg of protection and, again, there has been some variance in terms of how quickly countries have rolled them out. The vaccination process has been especially successful in the U.K., but Continental Europe has also been among the leaders in delivering shots, and we are optimistic that the worst is now behind us as vaccination programs accelerate over the summer.
The U.K. has shifted away from economic austerity, and we think it likely that the government will continue with expansionary fiscal policy until at least 2023. In Continental Europe, a large economic recovery plan was adopted in February of this year. Such responses by central authorities should work to insulate the European economies from the worst of the pandemic. Both plans focus on “green” technology and other new areas of innovation and will help the region to develop its capabilities in terms of digitization and the transition to cleaner energy programs.
The next German federal election will take place later this year in September. The traditional “big-tent” parties continue to suffer from a decline in voter support, and it is possible that the Green Party will come to power in a coalition and that its leader, Annalena Baerbock, could become the new chancellor. Such an outcome would raise the possibility that Germany turns its back on economic austerity, echoing developments we have seen in the U.S. Much of this about-turn would be directed toward addressing climate change and will again ensure that Europe has a leading position in this area.
In the short term, equity markets have been led by improving macroeconomic indicators, and earnings expectations have dutifully improved. At these times, the breadth of the market narrows and lowly rated companies that have underperformed in the preceding downturn tend to perform very strongly. During the current cycle, the sector that has most consistently outperformed during the upturn has been Financials, and within it, banks, and insurance companies.
In conclusion, the missteps, and recriminations aside, it is possible that future generations will look back and think that Europe dealt with COVID-19 fairly well. Many risks remain: vaccination programs may stall; dangerous new variants may continue to emerge; the political viability of lockdowns may exhaust itself. But given the scale of the problem and its lack of precedent, the response has been acceptable in our view. Politicians in Europe are beginning to move away from wholesale support for austerity, and digitization has leaped forward and is changing the rules in many industries. We believe the changes to come willcome, will benefit the types of companies in our portfolios. Many of these companies have shown their ability to thrive in periods of disruption and demonstrated this ability over long periods of time.
JAPAN: Focus on global economic recovery plays and companies benefitting from weaker yen
We expect the impact of COVID-19 on Japanese economic activity to recede. Strong exports are helping to offset the negative impact of COVID-19, rising 38.0% year over year in April, for the fastest increase in 11 years, and following a 16.1% rise in March. The gain was due to U.S.-bound auto-related shipments and Chinese demand for chip-making equipment. Also, supporting a stronger outlook were a 0.6% month-on-month rise in the April manufacturing purchasing managers’ index and a 3.5% gain in export orders. Household spending appeared to be strengthening through March, but turned weaker in the second quarter, as COVID-19 cases surged in some regions. As of June 30th, Japan had an abysmally low vaccination rate of 11.6%, just ahead of the global average. Second-quarter inflation is forecast at 0.4% after a year of steady deflation. The rebound in prices is due to government stimulus, the release of pent-up consumer demand and higher crude-oil prices. The Bank of JapanOJ will likely focus on maintaining financial conditions through bond transactions and lending programs. Employment has been holding up surprisingly well, with the 2.9% jobless rate in the first quarter of 2021 not much higher than the 2.4% rate before the spread of COVID-19.
The yen is a key driver for Japanese equities and has faced several headwinds this year. Among them were a stubborn rise in COVID-19 cases and related mobility restrictions in major population centers including Tokyo. The Japanese yen has been the G10’s worst-performing currency year-to-date, as its link to rising Treasury yields was re-established. We believe this link should ease going forward as the volatility in U.S. 10-year yields subsides. A few other factors supporting the yen are its cheap valuation, Japan’s improved balance of payments, and large short yen positions, whichthat we expect will get squeezed as the U.S. dollar declines. Japanese inflation-adjusted yields may also attract capital or at least stem capital outflows, as they are higher than in any other G10 country due to the country’s persistently low inflation rate. We continue to favor companies that will be beneficiaries of the global economic recovery and weaker yen currency.
ASIA PACIFIC: Remain optimistic about the outlook for Asian equities
Asian equities pulled back over the past three months after reaching record highs in February, as a resurgence in COVID-19 cases in India and Southeast Asia offset faster global economic growth and expectations waned that private consumption would recover in the second half of 2021. Progress on vaccinations in much of Europe and North America has helped to accelerate global growth, as has increased demand for technology and supported easier financial conditions. Much of this backdrop benefits select Asian economies.
Going forward, even more robust economic growth, in our view, is likely in China, India, Singapore and South Korea, while growth in Thailand, Malaysia and Philippines is likely to disappoint. Inflation is rising given higher commodity prices, supply-chain bottlenecks, and the fact that prices were depressed by the pandemic in the year-ago period. We expect central banks to leave policy rates unchanged this year, but central bank interest rate increases are likely next year in China, India, Indonesia, Malaysia, and the Philippines. We remain optimistic about the outlook for Asian equities, but we are keeping a close eye on the shift away from highly valued growth sectors since the fourth quarter of 2020. For example, Singapore has benefited from this style rotation, whereas China, which is driven by growth stocks, has not.
EMERGING MARKETS: Poised for a period of outperformance
Emerging markets, have in recent months, ceded some of their outperformance versus developed markets due to a first-quarter rally in the U.S. dollar and a sharp decline in Chinese stocks, which account for a significant portion of the emerging market index. This performance masks the dramatic change in style leadership that kicked off in late 2020, as optimism over the reopening of economies led to outperformance in value and cyclical stocks following several years of underperformance. The shift was supported by a backdrop of pent-up demand, along with loose U.S. monetary and fiscal policy that led to rising inflation expectations.
Changes in the performance of emerging-market equities relative to developed markets tend to occur in waves, with long periods of strong outperformance, followed by long periods of underperformance. Emerging markets outperformed strongly between 2000 and 2010, but have mostly underperformed for the past decade. The factors that generally drive the relative performance of emerging markets have been the U.S. dollar and the size of the gap in economic growth and earnings between emerging and developed markets. Looking forward, we believe that the case is relatively strong, that these factors will turn positive and that emerging markets will enter a period of outperformance.
CURRENCIES: U.S. dollar can fall further
After a year, in which the U.S. dollar lost more than 10% of its value, the key question facing investors is whether the dollar is on the verge of a rebound that reflects a U.S. recovery, successful vaccination programs and an economic reopening. Our answer remains, that the U.S. dollar has further to fall as the greenback’s multi-year decline is still in its early stages and longer-term drivers continue to weigh on the currency. Short-term rallies in the dollar should be expected, but investors with longer investment horizons will be rewarded for sticking with a bearish stance. We believe that the dollar is in the first half of a broad-based bear market, and we are particularly positive on cyclical currencies that will benefit most from the global reopening.
CURRENT STATE AND THE OUTLOOK FROM HERE: Remain overweight equities
The global economic recovery is fanned by the cyclical tailwinds of massive monetary and fiscal stimulus, an easing of virus-related restrictions, and low interest rates. We continue to expect strong global economic growth in 2021 and again next year, as the economy accelerates at a rate that supports solid corporate profit gains. In this environment, we think a significant overweight in equities remains appropriate. Ultra-low return expectations in fixed income, motivates our decision to remain overweight global equities. Investors with long-term savings plans, in our view, would likely want to minimize exposure to low-returning sovereign bonds and boost equity allocations. That said, the powerful advance of U.S. equities over the past year prompts us to recognize that their valuations are full and that the risk premium between stocks and bonds has narrowed somewhat.