How long will the equity market resurgence continue?

June, 2021 Print

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Emma Powell, LAPF Investments.

Emma Powell discusses the prospects for equity markets on both sides of the atlantic and concludes that investors should be considering companies with long-term earnings potential as well as those benefiting from the current low interest regime


The lights are flashing green for equity markets in Europe and the US. Ultra-low interest rates and fresh waves of quantitative easing in the wake of the pandemic have sent investors further into stock markets, in the hope of generating higher returns than those on offer in government debt. Meanwhile government spending programmes and the successful rollout of vaccine programmes have cemented hopes in economic recovery, which has spurred equity valuations higher.

The S&P 500 has regained all ground lost during last year’s crash and stands at an all-time high, powered by the spectacular surge in high growth tech stocks. However, the FTSE 100 has also enjoyed a resurgence. At the time of writing, it had broken back through the 7,000-mark, after gaining more than a third since March.

The steep recovery in developed market equity indices has been propelled by multiple factors. In the US, a $1.9 trillion package of spending signed into law by President Biden in March has powered economic recovery hopes. Meanwhile, the US central bank’s decision to extend its debt purchasing activity in the wake of the pandemic has meant US treasury yields have remained subdued, sending investors into riskier assets.

The UK government’s extensive financial support package, extensive bond buying by the Bank of England and the decision to keep base rates at an historically low level have had a similarly positive impact on equity markets. While stock markets on both sides of the Atlantic have been boosted by the successful rollout of vaccine programmes.

In the UK, hopes for a speedy economic recovery have prompted a shift from reliable, growth stocks towards value since the start of the year. Companies in sectors including financial services, commodities and leisure have enjoyed substantial share price gains since the start of the year. The top three highest total return stocks in the FTSE 350 since the start of the year are Wagamama owner Restaurant Group, oil explorer and producer Tullow Oil and iron ore miner Ferrexpo.

“I remain very bullish towards the value end of the market and the recovery theme,” says Lewis Grant, senior global equities portfolio manager at Federated Hermes. Banks, which are a traditional value play, are a good example, he says.

Recently, banks such as Lloyds and Natwest unveiled first quarter profits that beat analyst expectations because they could unwind provisions previously taken for bad debts. Admittedly, Interest rates might not have risen yet, he says. “But that is going to be the direction of travel soon, it’s certainly not going to go the other way,” he adds.

However, Grant says: “People need to be slightly cautious about which types of value stocks they invest in. For instance, not all commodities are worthy investments, with a longer-term investment horizon in mind. Copper and aluminium, there’s definitely long-term demand there,” he says. However, even though oil is having a good time now, over the long term earnings could be hit as governments shift towards decarbonisation, Grant continued.

Grant says he also looks for companies with pricing power, which can deliver earnings growth in the recovery, rather than being “cheap for the sake of being cheap”.

Dividend prospects have also improved for UK stocks, with the fall in payouts slowing during the first quarter to the lowest rate since the pandemic took hold, according to the Link dividend monitor. Link expects underlying dividends to rise almost 6% this year.

However, Grant says investors can get too hung up on companies paying high dividends, which can leave a company susceptible to sharp sell-offs when it cuts payouts. “In an ideal world the company would see an opportunity to use that cash in another way,” he says.

 

 

Can the good times continue?
US equity markets only stumbled when the pandemic struck, driven by defensive tech stocks, which benefited from increased sales during lockdown. Information technology companies account for the largest proportion of the S&P 500 at just over 26%. The soaring share price gains enjoyed by those companies have left the index valued at 23 times forecast earnings, above a multiple of 20 at the start of last year.

“Those large cap names are expensive by traditional metrics,” says Grant. However, the growth that those mega-cap companies are delivering justifies those metrics, he says. Share buybacks from some, including Google parent Alphabet, add to the appeal, Grant continued.

The FAANG companies delivered earnings that outperformed expectations by a considerable margin during the first quarter. Strong performances not just from those companies, but value stocks such as US banks, prompted upgrades in earnings forecasts among analysts. That has meant that the valuation of the index has come down from an all-time high of 28 in February.

Shoqat Bunglawala, head of multi-asset solutions, international at Goldman Sachs Asset Management agrees that the valuation multiple attached to the US index might look elevated relative to history. “But not when you compare to the yield available on 10-year bonds,” he says.

He also points to the relative dividend yield generated by the S&P 500 versus 10-year US treasuries during the tech bubble. The former was around 1%, compared with 6% on 10-year US bonds, he says. At the time of writing those were now broadly even at around 1.5%, based upon dividends paid during the last 12 months.

Nevertheless, US treasury yields have started to rise as the enormous amount of cash pumped into the economy has given way to rising inflation, stoking expectations that the Federal Reserve will increase the federal funds rate. In response, ten-year treasury yields have risen to around 1.56%, up from a trough of 0.5% in June.

Those inflationary jitters have spread to the UK. However, in early May, the Bank of England allayed market fears – at least temporarily – that rising inflation could spark a rise in the base rate. What’s more, the central bank lifted forecasts for gross domestic product this year to 7.25%, from the 5% expected in February, the fastest rate in over 80 years.

The prospect of rising interest rates is another reason for a tempering of the multiple gap between classic growth stocks and value stocks, says Ken McAtamney, Head of global equity team, William Blair Investment Management. “With higher interest rates, the value of future corporate cash flows is reduced as well, and as expected, we are seeing the valuation multiples of long-duration earners contract,” he says.

Equity market jitters were intensified in May by US Treasury Secretary Janet Yellen’s comments that interest rates may need to rise over time to ensure the US economy does not overheat. The remarks exacerbated a sell-off in tech stocks.

It is more the pace of rate rises – and subsequent increase in bond yields – that’s likely to impact growth areas of the market, says Bunglawala. “We are likely to see a much more gradual increase in bond yields,” he adds.

While UK and US stocks have been on a tear in recent months, the picture is more complex for emerging market equities. Since the start of the year inflows into emerging market equities have scaled back, according to the Institute of International Finance. In March, inflows declined to just $0.2 billion and showed only marginal gains in April at $0.7 billion, predominantly thanks to a strong showing from Chinese equities.

Goldman Sachs Asset Management holds emerging market equities as part of its long-term strategic asset allocation. However, it is currently neutral towards the market, partly due to the fact that there are challenges to the vaccine rollout in some developing countries, says Bunglawala.

Aside from pandemic-related risks, an improvement in Chinese GDP also means monetary and fiscal policy is not as accommodative, he adds. “That’s had an impact on equity returns in EM,” says Bunglawala.

However, he expects to see more positive earnings momentum in EM as there is more progress on the vaccine roll out front, he says. What’s more, weighting yourself towards procyclical US stocks “ensures you’re managing the risk of maintaining exposure to a range of unintended bets,” he adds.

Some corners of the US equity market look incredibly expensive by traditional valuation metrics. Better value might be on offer on the other side of the pond. Yet for now, indications from central banks are that interest rates will not be raised any time soon. While that may ensure the rally in equity markets will not abate any time soon, investors would do well to pay closer heed to sifting quality companies with long-term earnings potential from those benefiting from the rising tide.

 

FOCUS Global Equities

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