Is equity optimism overdone?

12 March 2021

7 minute read

Equities are on a roll this year, fueled by hopes of a vaccine-led recovery and encouraging earnings numbers. But are valuations heading for a fall given seemingly ignored risks of vaccine problems, mistimed policy withdrawal and inflation threats?

Key points:

  • With valuations elevated, the risk-reward for equities appears balanced
  • A bull case scenario for 2021 seems more likely
  • Surging inflation and the reversal of fiscal and monetary stimulus seem to be the biggest downside risks for investors
  • A stronger, quicker recovery than expected ranks among the top upside risks this year
  • Focusing on an active approach to investing and allocating to “quality” companies seems preferable.

After rising as much as 6% in the first two months of the year, global equities have given up some gains so far in March. With negative surprises still potentially on the horizon, risk-reward seems balanced. However, surges in volatility likely lie ahead.

Earnings driver

The final three months of last year are posting stronger earnings than expected. Over 80% of reporting companies beat consensus’ forecast in the US. Incredibly, fourth-quarter (Q4) earnings growth is on track to reach 3.5% rather than plunging by 8% as expected initially. Remember, comparator earnings in 2019 were unaffected by the COVID-19 outbreak. Additionally, anticipated earnings for the next twelve months are on the rise.

European earnings are more mixed, Q4 numbers shrinking by at least 15%. Most of the difference between American and European earnings for the quarter can be explained by diverging index composition, the latter being much more exposed to the energy and financial sectors and less to technology ones.

Enter the bull?

As a result of much stronger-than-expected Q4 earnings, equity markets’ fair value appears to be closer to our bull case scenario for 2021 (in the 3,900-4,000 range on the S&P 500). That said, this scenario assumes recovery through the year, backed by accommodative stimulus policies and successful COVID-19 vaccination campaign, cutting infection levels, in most of the developed world.

Downside risks

If any of the above assumptions do not deliver, the outcome is at risk of disappointing. Top of the worry pile is inflation, already on many investors’ minds. Recovery, base effects, stronger commodity prices and value-chain stress (like potential delays in supplying semiconductors due to unexpectedly strong demand) may see sharp rises in prices.

While a temporary surge in inflation is probably manageable, a sustained rise in prices would be a concern. Though moderate inflation (as opposed to deflation risk) may be welcome, persisting negative interest rates in Europe and low ones in America seem inappropriate for times when the inverse relationship between inflation and unemployment re-establishes itself.

Recalibrating monetary policy to prevent the economy from overheating may require central banks to adopt much tighter policy, possibly exerting downside pressure on equity valuations.

Fiscal pressures

Outside of the risk of the pandemic becoming a feature of the world we live in for years to come, hitting recovery hopes, the other possible issue worth highlighting is around fiscal stimulus.

One of the biggest reasons why recovery from the pandemic shock is relatively quick is the bumper government bail outs offered during the crisis. However, as the debt burden and budget deficits balloon, at some point governments may have to pull the plug. That could spook financial markets and hinder growth.

Reversing stimulus measures would likely lead to a surge in bankruptcies, spike in the unemployment rate and bleaker outlook for companies. A knock-on effect could be to compromise the pace of the earnings recovery, hitting sentiment and asset prices. While such an outcome may trigger additional monetary support eventually, it would leave a mark.

On the upside

Much positive news already seems to be discounted by the market. That said, two particular upside risks seem worth keeping an eye on.

The first one relies on even stronger-than-anticipated earnings growth. After months of lockdown measures for consumers and spending being curtailed, pent-up demand might be significantly higher than initially thought.

Another upside risk could be a quicker return to normal than consensus anticipates, as suggested by January’s US retail sales performance. This appears an unlikely scenario in the short term. However, the combination of vaccines capable of fighting variants of the virus and better treatments for infected people could allow some badly affected industries (travel and leisure in particular) to recover ahead of schedule.

Active investing appeals

Upside at the index level appears limited for now. That said, investment opportunities can be tracked down, aided by likely elevated expectations, limited visibility and significant dispersion at both the sector and the stock level.

Wider dispersion in returns calls for a more active approach to investing, using stock picking to unearth opportunities in a world were beta might be less relevant. A bias to investing in “quality” companies, those with resilient free cash flow generation and attractive medium-term growth prospects, has appeal.

In addition, well diversified portfolios can help to mitigate the effects of known risks along with potentially extreme ones, so-called “black swan”, when they occur. This is why adopting a balanced portfolio approach seems preferable.

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