May 2021 - Monthly House Views

Hanging Loose

The momentum from a buoyant first quarter has carried through into the spring with more robust global economic indicators. While manufacturing already entered a renaissance of sorts last year with global demand for physical goods soaring following the pandemic, demand for services – the bulk of economic activity in advanced economies – also appears to be accelerating now as lockdowns ease and vaccinations proliferate.

In the Eurozone, the Purchasing Managers Index (PMI) for services rose to 50.5 last month (with 50 marking the dividing line between growth and contraction). This is the first expansionary signal since last August. In China, consumer sentiment strengthened to the highest on record amid hopes of a strong post-pandemic recovery, pushing the services PMI up to 56.3. The recovery in services confidence in the UK and US is even more extraordinary, with each registering PMI figures above 60 in April. It is no coincidence that both lead the world’s largest countries in terms of vaccinations, with the UK and the US having administered at least one dose of a coronavirus vaccine to huge swathes of their respective populations (52% and 45%* ).

The resurgence in services is a critical factor behind what is a spectacular macroeconomic surge. In April, the International Monetary Fund upgraded its global growth projections to 6% for 2021 and 4.4% in 2022.  This growth is also translating into strong corporate earnings. For US equities, the earnings growth rate for this year is expected to be about 33%, followed by 13% next year and the 52-week forward expectations for revenues, profit margins and earnings have all risen to record highs. The Eurozone and the UK should also have banner years for earnings growth, albeit from deeper troughs.

For now, this robust macroeconomic backdrop continues to anchor the dazzling momentum in risk assets. Admittedly, valuations for these assets are elevated by any historical measure, which is a cause of concern. With such a strong economic backdrop, further rises in rates are possible, which is one of the chief risks for the ongoing bull market and its extended valuations. Some would argue that it has already begun. In late April, the Bank of Canada (BoC) was the first to move when it announced the tapering of its asset purchases from C$4bn per week to C$3bn. It justified this move by pointing to a dramatic upgrade in its forecasts – 2021 growth estimates have jumped to 6.5% from only 4% in January and the BoC now expects that by H2 2022, all economic slack will have been absorbed and inflation will be sustainable around its 2% target. 

At its meeting in early May, the Bank of England (BoE) made no headline changes to policy settings, keeping its policy rate at 0.1% and holding the total size of its asset purchase programme steady at £895bn. However, like the BoC, the BoE revised its 2021 growth forecasts higher, to 7.25% versus its previous 5% estimate. This means that GDP will be back to pre-crisis levels by Q4 this year, a quarter earlier than previously thought, thanks to faster consumption of pent-up demand. It also announced it would reduce the weekly pace of its asset purchases, from £4.44bn to £3.44bn.

However, the above must be taken in context. BoE governor Bailey went out of his way to emphasise that this was a mechanical change rather than a signal for policy being tightened. The BoE had fixed a £190bn envelope for asset purchases this year, implying a £3.7bn weekly rate – by reducing the weekly pace, it is simply spreading the remaining purchases out evenly over the rest of the year. 

Moreover, the European Central Bank (ECB) and the Federal Reserve (Fed) show no sign of following suit. The ECB announced that it would accelerate the pace of asset purchases in Q2 given the perceived tightening in monetary conditions and, indeed, the weekly pace of its Pandemic Emergency Purchase Programme buying has accelerated by 33% since Easter, reaching €25.3bn in mid-April. 

The US Fed has stuck to its monthly target of $120bn in purchases despite the recent string of stronger confidence data – for example, the March Institute of Supply Management survey of manufacturers hit a 37-year high, before easing back in April. Although the economic outlook has brightened, there is still a long way to go before the Fed tightens – one-fifth of the workforce in lower income categories is still unemployed and the Fed remains convinced that this year’s spike in inflation will prove transitory. These views were given some weight by the April payroll data – observers were disappointed to see only 266,000 new jobs added and the unemployment rate edging up to 6.1%.

Bottom line

We remain sanguine and believe it unlikely that rates will rise rapidly for many months to come, if not years. This is primarily guided by our view that inflation expectations should remain anchored at low levels. This year should see higher prices as economies reopen and pent-up consumer demand is unleashed, but this should prove transitory – gaps between actual and potential output still gape wide, there is enormous slack in the labour market and huge underutilised capacity in commercial real estate.

We remain risk-on. As always, we are guided by the four pillars of our investment process:  

  • Economic regime: Our Leading Economic Macro Indicator (LEMI) suggests the global economy is in a state of expansion, which is clearly favourable for risk-taking.  Each of the ten underlying forward indicators of economic growth are positive – an unusual confluence – which is reflective of a broad and powerful economic backdrop.  
  • Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms. Heightened valuations have been further challenged by increased inflation expectations, which raises the spectre of rates rising. However, as discussed above, we believe central banks have little appetite to raise rates at present and inflation is likely to remain subdued over time, albeit a transitory rise may well occur. We remain tolerant of higher global equity valuations at the headline level but have been tilting our exposure towards less expensive regions.    
  • Momentum: Global equities are in positive momentum versus their ten-month moving average. This is supportive of increasing exposure to the asset class.  
  • Sentiment: Sentiment remains bullish. Nonetheless, we remain within our risk tolerances.

We believe the case for risk-taking is well supported given a strengthening economic backdrop and strong momentum. Nonetheless, we are wary of expensive valuations and bullish sentiment. On balance, we are moderately risk-on with a continued preference for equities but have been tilting more towards less expensive, value-oriented regions. We also continue to hold a stable of safe-haven assets, including gold, low-volatility, defensive alternatives (e.g. hedge funds) and government bonds.

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