28 april 2021
Welcome to CLEARCUT, a monthly discussion on macro and allocation
Trust history_ April is historically the strongest month of the year for financial markets and 2021 proved bears wrong again. The macro environment remains very supportive as the global economy is approaching peak growth, while central banks contained the rise in bond yields, prolonging goldilocks market conditions. With the S&P 500 up another 5% over the month, how long can this go?
Peak growth_ An economic boom was widely anticipated once pandemic-hit sectors could reopen. Still, seeing it happen is always better than just expecting it. In March, US retail sales were up 10% while the private sector created nearly one million jobs. Higher-frequency indicators, such as the weekly Redbook sales suggest another strong inflection point in early April (Exhibit 1). In effect, the boom we had described last month is starting to materialise and puts the US economy on a path to deliver ca. 7% growth this year.
The old man stretches his legs_ The novel development is that Europe is starting to follow suit. With a lag of about 3-4 months, the pace of vaccination has markedly accelerated since March, reaching about 2.5 million daily vaccinations. Several countries started relaxing constraints and the economic inflection is perceptible in business surveys, if not yet in hard data. April services PMIs for example climbed back above 50 for the first time since August 2020. In effect, the pandemic is disappearing as a market issue for developed economies. It remains critical in some emerging markets still battling against the virus, especially India.
Next generation_ In Europe, optimism is also strengthened by the political dynamics. Italian PM Draghi has presented his plan to spend nearly €250bn (15% of GDP) over the coming five years to boost and reform the economy. He presented it in dramatic terms, as a “wager” whereby the destiny of the country was at stake. Renewal is also in the air in Germany, where the September federal election is looming. Recent polls show that the Green candidate A. Baerbock is a serious contender and may become the next Chancellor in case her party does better than CDU candidate A. Laschet.
Exhibit 1: US consumers are back
Source: Redbook, SILEX – April 2021
Taxing times_ A key risk identified by markets in recent policy developments is a rise in US taxes. The Biden administration is planning to raise corporate tax, partly offsetting the cuts introduced under Trump in 2017, as well as capital gain taxes for the wealthiest households. These will help finance big spending plans in the green transition, jobs, education, and poverty alleviation. Arguments have been made that these measures may threaten the bull market, by weighing on earnings and investors’ appetite. None of these sounds convincing.
Scarce evidence_ First, corporate tax in the US is low, especially since 2018 (Exhibit 2). Companies are also notoriously paying much less than this rate, exploiting various loopholes in the tax system. The Biden plan, which may well be watered down in Congress, envisages to raise the statutory rate to 28% over 15 years, leaving plenty of time for firms to adjust. The administration has also called for coordinated action to raise taxes globally and reduce tax competition. Overall, this does not seem likely to jeopardise investment and profits for the coming years, with 2022 EPS estimated to be reduced by just 2-3% by the tax hike. The capital gain tax also seems unlikely to deter investors. Research suggests that tax has a limited impact on investment decisions, while most end investors are in fact tax insensitive. Finally, the wave of retail investors that have agitated markets in recent months are unlikely to be part of the super-rich targeted by the new measure.
Exhibit 2: Some room to raise US corporate tax
Source: OECD, SILEX – April 2021
Sleepy_ A final point about central banks: after they prevented a disorderly rise in global interest rates last month, the ECB and the Fed are unlikely to make significant decisions in the near term. Rather, part of their strategy is to let the economy run a bit hot and only hint at policy tightening after summer. As a result, the next three months should be quiet on the monetary front.
Ice and fire_ The striking feature of current markets is how extreme indicators are. On the macro side, peak economic growth is translating into extremely positive earnings prospects for most sectors. At the same time, valuations are also close to all-time highs, even after discounting growth in coming years. Finally, positioning is close to extreme highs across indicators, be it retail or institutional allocations, pricing of risk or flows. In which direction is this going to turn?
Exhibit 3: Massive earnings growth ahead
Source: IBES, SILEX – April 2021
Earnings Eldorado_ The starting point is how much earnings are likely to grow in coming years. On current estimates, US earnings have fallen about 12% last year and are expected to grow 30% this year and another 10%+ in 2022 and 2023 (Exhibit 3). This trajectory is the logical consequence of the economic growth in the coming 18 months, in the aftermath of general re-openings. It also has to do with improving returns on equity related to the decline in the cost of capital that firms have benefited from. They have generally increased financial leverage and optimised balance sheets so that more of every incremental dollar in sales feeds the bottom line.
Beyond 2000_ Extraordinary earnings prospects are nevertheless reflected in current valuations. Simple valuation gauges such as price to earnings ratios or Warren Buffet’s preferred market cap to GDP point to significant overvaluation compared to historical norms. More sophisticated measures that attempt to incorporate future growth, such as price to earnings in three years, suggest still elevated levels of valuation (Exhibit 4). The US market is currently in the 98th percentile since 2001, the eurozone in the 94th. Valuation is a difficult concept to use though. Not only is it a poor timing tool, as valuations can remain extreme for some time, but at least two arguments can be made about a regime change in valuation over the past decade.
Paying for growth_ First, as is widely known, ultra-low interest rates are now a feature of financial markets that has lowered discount rates in equity valuation models but also led to portfolio rebalancing. Investors are pushed to more attractive alternatives when bond yields stand at rock bottom. Second, the digital revolution may have led to sustainably higher valuations than the Fordist economy. Mega-cap companies can sustain higher growth rates and therefore higher multiples because of increasing returns to scale. The larger a company is, the larger it can become. Also, public equity valuations are converging to venture capital approaches. When uncertainty is high and potential growth is explosive, tech stocks include optionality value reflected in multiples. Taken individually, each stock may look too expensive compared to its modal growth scenario. But collectively in a portfolio, their valuation includes the possibility that one of them will deliver 100x returns.
Exhibit 4: High valuations
Source: IBES, SILEX – April 2021
Everyone’s in_ In these crosscurrents, the most reliable indicator may be positioning. Anecdotal evidence is clear that the market is overheating in some areas. Broader and more systematic measures are also pointing to high levels of participation in the equity market recently. True, the frenzy has moderated from retail investors compared to earlier this year, when sizable parts of federal payments had found their way into the equity market. But surveys about private wealth or institutional investors show record high level of equity allocation. Our own measure of cross-asset positioning, that includes a variety of metrics from surveys to option prices and flows, flashes above the 70th percentile (Exhibit 5). Betting on a reversal in sentiment is difficult because it merely reflects the vulnerability of current pricing to bad news. Stretched positioning suggests that in case something bad happens, there will likely be more sellers than buyers available.
Looking for hints_ Where could bad news come from? Once the current earning season is over, additional positive catalysts may become scarcer. The main downside risk would be a resumption of the upward trend in interest rates. The momentum in inflation is picking up and reflected in bond yields. Not only can inflation expectations continue grinding higher, but it seems unlikely that that rise will be offset by falling real rates for much longer. The most likely is in fact that both the real and nominal components of interest rates correlate again and rise in the second half of the year.
Exhibit 5: Frothy sentiment
Source: Bloomberg, BofA, AAII, SILEX – April 2021
Not much on the radar_ Other risks on the radar look more benign. As discussed above, the tax rise in the US is not likely to derail the market dynamics in any significant ways. A disappointment in the execution of fiscal stimulus in the US or Europe is possible, but also unlikely to have a material impact. The Covid-19 pandemic remains a small pocket of uncertainty but the race against the clock seems to have been won. In fact, the genuine unknown for the rest of this year is once again geopolitical risk. The “wolf warrior” diplomacy in China suggests that any occasion to prove its assertiveness could be used in a much different way compared to the ‘trade war’ in 2018. Russia is also a good candidate for geopolitical and cyber trouble, as the recent Ukrainian episode reminded us.
Spreading_ Fixed income has therefore become of crucial importance for the rest of the year. In our expectations, carry will deliver most of performance given that duration should deliver more risk than reward. Short-duration high yield makes most sense as a result, despite already tight spreads. European financial debt should continue its strong run, reaching new post-GFC tights as liability exercises accelerate towards the end of the grandfathering period.
Exhibit 6: SPARK expected returns and Sharpe ratios
Source: SILEX. Euro-based investors – April 2021
In a nutshell_ SPARK continues to give priority to equities for now. They offer the best Sharpe ratio, although expected returns have declined after the strong run. This is also due to the lack of alternative, as credit expected returns have also fallen with spreads tightening. Government debt is a clear underweight at these levels: a tactical approach to duration looks the most appropriate to navigate the policy shift to come.