Equities: running out of puff?

Key points:

• The “bull case” for US equities looks promising as fresh highs are reached
• Despite the upbeat mood, gains appear likely to be more of a struggle as positive surprises are tougher to come by and recovery momentum slows
• Sectors linked to climate change, new technologies and healthcare seem to have strong growth potential whatever shape the pandemic takes next
• At this stage of the recovery, neutral levels of cyclical exposure seem more appropriate, while targeting quality rather than value opportunities
• Portfolio diversification and active management looks particularly appealing at the moment.

The “bull case” for US equities looks promising as earnings for the first three months of the year lift consensus full-year 2021 earnings per share (EPS) estimates to $180 from $170 for the S&P 500.

Caution called for

The outlook for equities may be promising, however gains appear likely to be more of a struggle as surprises on the upside may be tougher to come by. Equities tend to respond to momentum, rather than to their absolute level. Momentum might slow this year on many fronts as “peaks”, such as for earnings and global economic growth, come and go. While this need not signal a correction for equities, short-term upside might be limited.

The economic growth rate may soon slow

Economic momentum is the first of the peaks on the horizon. China and the US, the two largest economies, look particularly susceptible to this one.

Chinese gross domestic product (GDP) climbed by 18.3% year-on-year in the first quarter. That said, comparison with the first quarter of last year was made easier given the sharp, sudden contraction in output then, as the effects of COVID-19 surfaced. Indeed, the growth rate slowed to 0.6% on a quarter-on-quarter basis, suggesting a slowing recovery.

In the US, the ISM services index of activity climbed to a 63.7 high in March, pointing to a healthy economy. While the economy may improve in the next couple of months, as activity picks up, the rate of progress is likely to slow as output returns to pre-coronavirus levels.

What next for monetary policy?

Central banks’ accommodative responses to the pandemic have underpinned the charge in equities seen since March 2020. By injecting record liquidity into financial markets and keeping interest rates low, monetary policy has helped to lift valuations and risk appetite. That said, excluding a resurging pandemic, it’s difficult to envisage more dovish policy this year. While a tighter stance may be at least some quarters away, the liquidity impulse is likely to slow.

Have government spending commitments reached their limits?

Like central banks, governments took a “whatever it takes” approach to the pandemic response. Investors have a better understanding now of the size and scope of Joe Biden’s administration’s policy plans. Importantly, additional government spending isn’t unequivocally positive for equities, given spending offsets in the form of higher tax rates.

In the UK, the government set a precedent this year when announcing corporate tax rates would rise from 2023. In Europe, there may be some wiggle room, but timing is an issue as member states are yet to receive money from the €750bn recovery package that was approved last year.

Peak earnings growth

There appears little question that company earnings can keep growing, including in the short term, supporting the rationale for allocating to equities. The consensus expects year-on-year S&P 500 EPS growth of 34%, 57%, 21% and 15%, respectively, in the four quarters of this year. However, growth looks set to slow from the third quarter and this momentum shift may challenge valuations.

Other peaks: vaccinations and inflation

Two other variables, the pace of vaccinations and inflation, look like peaking too this year. First, the economic benefits flowing from vaccinating more people, especially in the developed world, may slip on reaching herd immunity. Second, inflationary pressures might peak in the summer. In turn, this suggests that the recovery could be running out of puff.

Upbeat mood for now

The state of the recovery is not the only factor driving sentiment. As the recovery loses momentum, other factors could pick up. First, this year’s generally buoyant investor mood and healthy equity inflows are not backed up by positioning, which seems relatively limited still. Second, in a two-track recovery, China, the US and the UK might have, or be near, recovered, but growth in continental Europe and most emerging markets lags. This could spark a second leg in the recovery.

While much of the focus for investors in the last year has been on the pandemic, areas of the economy can grow strongly, aside from COVID-19 trends. Sectors linked to climate change, new technologies (such as automation and artificial intelligence) and healthcare are cases in point.

Time to be invested and diversified

The long-term outlook remains encouraging and supportive for equity investors. With uncertainty to the fore, appropriate diversification through active management appears essential. However, because of the nearing momentum peaks, it may be time to reduce cyclical exposure to more neutral levels. This, combined with a focus on quality, may place portfolios well for what could be a bumpier road ahead.

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