The winding path to a post-pandemic world.
In our 2021 outlook we were embracing the optimism as the global economy was starting to heal. Fast forward six months and the global healing process has progressed into a genuine recovery. Nonetheless, some concerns have emerged along the way.
In the mid-year outlook we are turning our attention to some of the key questions that are on investor’s minds, and setting the stage for what we think can be another strong six months for risk assets. In today’s note, we wanted to share some key takeaways.
1. Are we in for another period of U.S. outperformance, or will the rest of the world catch up?
The top-down arguments for U.S. outperformance seem pretty clear: huge fiscal stimulus is being pushed through by the Biden administration, the vaccination roll-out is progressing faster than in most other major economies, and GDP growth expectations for the year are around 6%, the highest rate since 1980. But after an impressive rally off the March lows (the S&P 500 gained +61% between April 2020 and April 2021, outperforming other global markets in USD terms), it might also be worth looking at those regions that are yet to catch up.
Europe is one of those regions where vaccinations have gotten off to a slower start, and some restrictions remain in place, but the recovery is picking up pace and the Stoxx 600 has outperformed the U.S. market year-to-date by over +2% on a total return basis. We like this catch-up story, which also gets a further boost from the EU Recovery Fund, plus strong earnings growth and a wider-than-normal discount to the S&P 500.
Looking beyond Europe, certain countries in emerging markets also remain on our shopping list, in particular China. Yes, Chinese equities have underperformed year-to-date on the back of regulatory concerns. But 2020 was a strong year for the Chinese market as the country was the first in and the first out of the crisis, and long-term secular trends remain supportive. Going forward, balance will be key.
2. Should we be concerned about peaking growth? Is this as good as it gets?
Short answer: No. The U.S. economy has gone through the “V-shaped” recovery that we had anticipated, and Q2 will likely see the peak growth rates.
So what happens next? We think that the global economy can grow at an above-average rate until the end of 2022. Consumer savings remain high, inventories are low, and capacity needs to be added to keep up with demand. All of this makes us optimistic that growth can continue and risk assets will in turn benefit. In the longer term, potential GDP growth could run at a rate of around 2.25% in the new economic cycle, up from the currently assumed 1.8% growth rate. In fact, productivity has soared since the pandemic began. So yes, growth rates are peaking, but this does not mean that the good times are coming to an end.
But growth also brings higher inflation, no? Inflation has been the buzzword over the last few months and CPI prints spiked in April. However, we agree with the Fed and view the current trends as transitory. For what it’s worth, the market seems to agree with us. Take a look at the 10-year U.S. Treasury yields. They have gone sideways since April and actually have declined recently, now hovering around the 1.53% level. Lumber prices have declined -30% since peaking in early May, easing pressures on building costs.
But a healthy recovery also comes with a healthy amount of inflation, consistent with the Fed’s goals for an average of 2% over time. Clients should consider adding to cyclicals and value areas of the equity market (financials, industrials, energy), as well as to real assets like real estate and infrastructure.
3. Can equity markets keep rising, especially with higher taxes on the horizon?
As we mentioned above, the S&P 500 has had a phenomenal run since April last year, but we don’t think that this trend will reverse. It will just normalize. We continue to see mid-single to low-double digit upside to global equity markets, and it is mainly earnings growth that will fuel this over the next two years. We expect 40% EPS growth in the U.S. in 2021, followed by 10% in 2022.
But will taxes derail our positive outlook? No, we already include the potential impact of higher taxes in our forecasts and incorporate a ~$5 negative impact in our EPS numbers for 2022. So taxes, in our view, should not weigh on the mid-term outlook for equity markets and, in fact, any surprise to the upside on the fiscal stimulus front or delays on the tax hikes could give equities another boost.
We are nearing an important crossroads. A booming global economy, still-supportive monetary policy and impressive corporate earnings are powerful tailwinds to markets. But if inflation soars, onerous tax rates damage profits and the Fed pivot proves disruptive, the headwinds could be equally powerful. For now, we think the tailwinds will prevail.
- The Standard and Poor’s 500 Index is a capitalization-weighted index of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% of available market capitalization.
- The Stoxx Europe 600 Index has 600 fixed components and represents large, mid, and small capitalization companies across 17 countries of the European region.
- The MSCI China Index captures large and mid cap representation across China H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). The index covers about 85% of this China equity universe. Currently, the index also includes Large Cap A shares represented at 10% of their free float adjusted market capitalization
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