11 Oct 2021
1. Headwinds for corporate margins are growing
2. Supply chain costs and post-covid reopening costs could have negative implications
3. Rising taxes and wages may also impact bottom lines
There’s nothing quite as disconcerting as being told everything is set fair. Though growth and earnings remain positive, real yields plague fixed income markets. This is perpetuating the ‘TINA’ (There Is No Alternative) phenomenon for equities, even though they look expensive.
But high valuations and a positive consensual outlook are wary bedfellows, causing us to reflect on what could cause some temperance. Even though valuation corrections don’t always require market pullbacks, they do impact returns and so greater caution is necessary.
There are two main short-term concerns that could unsettle the outlook. Both margins and the 2020/2021 retracement of fiscal and monetary splurges suggest that valuation pullback in equities is a real possibility. The outlook is positive medium to long-term, but in the short-term we wouldn’t be surprised to see some volatility.
The summer saw markets steadily pricing-in concerns about slower economic growth and weaker inflation, leading to an unwind of the reflation trade. This has brought lower bond yields and in the equity market, outperformance of quality over value. The reversal has been so significant that the relative performance of value stocks is near to 2-year lows, while quality and growth equity indices near 2-year highs1. On a sector-neutral basis, the valuation dispersion between growth and value is now comparable to the extreme levels seen in 2000.
We’re not concerned about revenue expectations, given strong growth forecasts and higher savings ratios. The current earnings expectation of 6.9% for MSCI Europe is the lowest in 30 years and expectations are even more modest in the UK where implied 12-24m earnings growth is sub-3%2. However, one reason for this relatively anaemic forecast growth rate is the large increase in current year forecasts. Earnings have continued to be revised higher in all regions; Japan leading the way with close to all-time high earnings revisions. This has supported a 13.5% month-to-date rally in the Japanese equity market at the time of writing3.
The core reason for this is that many corporates have been able to cut office, travel and entertainment costs among others, as well as staff costs. Think reception, security and catering – many in these areas have been furloughed or laid off. This reduction in fixed costs, led to an historic increase in global margins of 280bps4. Notable, at a time that revenues didn’t fall as much as would be typically expected and given the historic fiscal programs to alleviate the impact of economic closure.
We are concerned about margins though. What impact will re-opening have here? Interestingly, there’s a lot of focus on the potential negative impact of supply chain costs but little in the way of discussion around the cost of Covid re-opening. We’re worried about the implications of both and about the implications of potential corporate tax increases which makes the current market consensus that margins will be flat year on year seem a little incongruous.
The second concern is the scale and speed of a pullback in monetary and fiscal policy support. In There’s been much discussion on monetary contraction around when tapering will start, but we think this misses a key point. The real change in absolute levels is what really matters. Globally, the positive impact of central bank asset purchases has already peaked and will be modest by the start of 2022 Q1. Though global tapering might not happen till Q4 2022, the positive impact of purchases stops by end Q1 (see chart below).
Pace of global central bank bond purchases decelerating
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Source: BoFA, 09/09/21
The European Central Bank (ECB) has announced a relatively dovish "taper" of its asset purchases for the fourth quarter of this year. Furthermore, the eurozone bond market has started to consider the prospects of ECB rate increases. The latest, relatively subdued ECB inflation forecasts, combined with the new rates guidance still - we think - mean the prospect of a lift-off in policy rates is some way off. This probably means that the eurozone rates sell-off (German 10-year yields have risen to -0.33% from a low of -0.54% in mid-August) has been overdone.
Turning to fiscal spending, though post global financial crisis (GFC) austerity discussions may feel like a lifetime ago, they’re likely to return to focus. The potential contraction in Government spending is currently forecast at -2.5% of global GDP in 2022, compared to a positive stimulus of 4% of GDP in 2020. This is assuming that governments stick to current plans and that Covid relief measures are not extended. But if it does materialise, this will be a tightening of policy five times larger than that seen after the GFC.
In Germany, the upcoming general election will bring this ‘expansion versus austerity’ debate into sharper focus. The expected winners are likely to have a more fiscally liberal approach which could include abandoning the Black Zero approach (one which doesn’t tolerate government budget deficits). But there’s no unified global approach to tackling the deterioration in government finances. The UK, where taxes will be increased to fund social care, suggests a different direction.
And in the US, there’s much more fiscal stimulus in the pipeline - around US$4.5tn (the US$1tn infrastructure package and the US$3.5tn American Families Plan). At over 20% of US GDP, this would be a record level of stimulus. To be passed, it will require a simple Senate majority, following a process of reconciliation. It could be too much for more conservative senators to accept. Democrat senator Joe Manchin of West Virginia publicly stated that the US$3.5tn package is too big and he cannot support it. The package will likely need to be reduced and may take longer to pass, especially given the more urgent issue of dealing with the debt ceiling. The US Treasury could well run out of money by November, raising the spectre of a US debt default once again.
It’s also worth noting developments in China. A bailout of Evergrande’s bond holders (largest property developer in China) seems unlikely as its loans seem sufficiently collateralised, reducing the risk of contagion. But once again, the company’s problems have focused concerns on the continuing clampdown by the state on some of the capitalist elements of the economy. This has concerned many foreign participants in Chinese financial markets enough to cause large outflows. The result is that valuations look attractive relative to other equity markets but like a post Brexit UK, the debate is whether these valuation levels will remain low relative to other markets.
Financial markets have been surprised by the world’s resilience to Covid-19 and the outlook for growth, revenues and earnings look good. This is a relatively consensual view though - and that appears to be well priced into market valuations. Trailing and forward price-to-earnings (P/E), enterprise value-to-EBIT and operating cash flow are all well into the 90th percentile. The cyclically adjusted P/E at 26.2x is well outside its historical 10-20x range and easily the highest outside of the tech bubble5.
We’re therefore vigilant in looking for catalysts that could hinder markets. Post-covid margin pressure and falling monetary and fiscal stimulus are top of that list at present. These raise the spectre of a short-term pull back in equities; but the ‘TINA’ phenomena remains a valid and potentially powerful force for equities. It is well illustrated by MSCI European equities having a 3% dividend yield compared with -2% for 10-year real bund yields2. This is close to a record high spread at circa 500bps - so we’re bullish long-term but in the short-term, wary.
Footnotes
1. MSCI Europe Value & MSCI Europe Growth
2. Morgan Stanley, 10/09/21
3. 20/08/21 – 14/09/21, Nikkei 225, Bloomberg
4. UBS
5. Deutsche Bank
Investment risks
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Data as at September 2021, unless otherwise stated.
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