Markets have started the year on a volatile note, with a brisk sell-off in some of the most popular technology names. Investors may need to adjust to a changing environment as inflation pressures rise and central banks change tack on interest rates. However, the global economy still holds plenty of firepower. Here's what we're thinking:
2021 – a year of big numbers
Seven billion vaccines delivered (1): a further US$9 trillion in stimulus (2) and global growth at an impressive 5.9% (3). This helped add US$13 trillion to the value of global stock markets (4). The Dallas Fed’s latest statistics show house prices rising by a record 8% in the third quarter of 2021 from a year ago (5). Higher asset prices lifted US aggregate net household worth to an all-time high of eight times annual take-home pay (6).
Consumer price inflation rose to multi-decade highs in the UK, Eurozone and US, pushed higher by accommodative policy, pent-up demand and supply chain difficulties. This saw the 10-year US Treasury bond deliver its sixth-worst performance this century in real terms (7). Inflation could stall consumer demand.
The global economy is in a favourable part of the business cycle for equities to rally. Our proprietary business activity indicator suggests the global economy is somewhere between ‘expansion’ and ‘late cycle’, or simply put, the mid-cycle. Looking back over the past 35 years, we find that global equities tend to rise by an annualised rate of 21% in the expansion phase and 9% in the late cycle, as compared to -12% during a cycle contraction (8).
The power of pent-up spending
Momentum may have slowed, but the global economy is still expanding. Households are sitting on cash squirreled away over the pandemic, leaving them with plenty of purchasing power, while restocking from record low levels should boost factory output and support new capital investment to drive the business cycle.
A new era on interest rates
Economic overheating could lead to higher rates that brings forward the contraction phase of the business cycle. Though that seems a low probability, research from Deutsche Bank finds that from 13 different Fed hiking periods since 1955 it has taken an average of 3½ years from the initial rate rise before higher rates tip the US economy into a contraction (9).
Wary on valuations
There remains the risk of a US equity bear market. At a time when economic outperformance may be peaking, and share price growth has largely been driven by multiple expansion rather than earnings growth, US shares look vulnerable.
Under the equity microscope: beware the megacaps
At first glance, cautioning against the megacaps (e.g. Amazon, Apple, Microsoft, Alphabet, Tesla and Meta Platforms, previously known as Facebook) seems problematic. The megacaps have made investors more money than any other part of the market over the past decade. Apple became the first company to hit a US$3 trillion valuation and its share price has risen almost five-fold in the last three years alone (10). The death knell has been sounded multiple times, but these high growth tech-related stocks have gone from strength to strength.
However, it is worth looking under the skin of why these companies have been so profitable for investors and asking whether this can endure. While they have undoubtedly delivered extraordinary earnings growth, Apple’s Price to Earnings ratio has risen from 12.5x at the start of 2019 to over 30x today. It is a similar picture for the other technology giants.
The megacaps have benefited from low interest rates, which have made their long-term cashflows more valuable: interest rates are an important tool in determining the value of future cashflows. Equally, during the pandemic they have often provided the tools to keep the world economy functioning, providing collaboration and communication mechanisms at a time of lockdowns. This has helped enshrine them as a new perceived ‘safe haven’, defensive stocks at a time when many companies faced an uncertain future.
However, we sense the tide is turning and many of these conditions are no longer in place. Monetary policy is turning, which will make the high valuations for these stocks hard to defend. Investors may become increasingly reluctant to pay high asking prices for the megacaps.
Their earnings may look lacklustre relative to the rest of the market in the quarters ahead. These companies have managed to sustain earnings through the pandemic, but this means they have more challenging comparative figures than many of their peers. As the economy recovers, investors may switch their attention to companies outpacing expectations.
Equally, as the pandemic recedes, which it eventually will, investors may no longer see the point in paying high prices for stability. A recovering economy will float all boats, so why pay high prices for the glamour of the megacaps?
If this sounds far-fetched, given the recent track record of these technology-related stocks, it is worth noting the disappointing performance of some of these megacap names since the start of the year. The high expectations built into these stocks mean that any change in sentiment could see them underperforming the market.
Against this backdrop, we are turning our attention elsewhere in 2022, believing investors don’t need to take the risk. They have served investors well, but it is time to look more broadly across the market. We believe there could be opportunities in the less fashionable markets of the UK, Europe and EM Asia, where valuations are more compelling and recovery is still in progress.
There is room for equities to outperform bonds but expect greater volatility. Stocks are a long-term hedge against inflation. We believe opportunities exist outside the US - notably Europe, UK and Emerging Asia. EM Asia could be in a particularly strong position if the US dollar peaks and China loosens policy, which is now happening. Within the US, investors should steer away from the megacaps, which are vulnerable to rising yields and have high valuations.
Current business and consumer confidence surveys suggest better times ahead for Eurozone equities, indicating healthy domestic demand. Companies in the region should also benefit from restocking demand as supply chain bottlenecks unwind. Corporate pricing power should push up profit margins and create room for Eurozone earnings to beat expectations. In general, we don’t believe equities reflect the strong operating leverage of many European companies, even if some risks around COVID remain.
Asia underperformed other regional markets in 2021, with China a notable weak spot. However, in the longer-term, China’s 'common prosperity' goal should lead to stable growth. The consumption trend is still robust, which is not just a boost to China but also to other Asian economies. Equally, the outlook on earnings growth is positive looking out into 2022 and 2023. Policy in China is also being eased, which is a positive for emerging markets. There are still risks – the zero-COVID policy could lead to further lockdowns and US dollar strength could be problematic, for example - but in general, current valuations reflect those risks.
Households face a drag on income from multiple sources over the coming quarters, but even if household real income is set for a squeeze, there are still plenty of pent-up savings to support the UK economy. Record job vacancies, rising labour income and a falling savings rate provide room for consumption to recover. Overall, more money is being spent at home than abroad, which supports domestic companies. This is where we are focused. However, with commodities prices rising, returns are likely to broaden out to the rest of the UK market (including energy and materials).
1, 3, 4, 5, 6 - Refinitiv, 4 January 2022
2 - The Thundering Word, Fin de Siècle, BofA, 21 November 2021
7 - Deutsche Bank Chart of the Day, 16 December 2021
8 - Smith & Williamson Investment Management LLP, 4 January 2022
9 - When the Fed hikes: what happens next? Deutsche Bank, 13 December 2021
10 - Apple becomes first U.S. company to reach $3 trillion market cap, CNBC, 3 January 2022
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.
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© Tilney Smith & Williamson Limited 2021
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.