Markets continued to be supported in the quarter by positive developments in COVID vaccine rollouts, a drop-off in cases, and the resulting talk of reopening economies. The economic outlook has improved so markedly that investors have now begun to turn to concerns of how policymakers may look too cool a hot economy. This has been felt most keenly in government bond markets, where yields have increased sharply to reflect the expectation that central banks may need to increase rates earlier than previously thought. The impact of higher bond yields and the implication of stronger economic growth has been felt in the equity market, both at an index level but more keenly at a sector level.
Many of those companies that have fared well through the pandemic have now underperformed sharply as investors have rotated into more cyclical and lower quality areas of the market. At a geographical level, this has seen markets such as the UK, which have a greater bias to these sectors, outperform after a prolonged period of underperformance. Provided that the current vaccination programme continues successfully, there appears to be little that may derail the rotation. However, as we have seen with the rise of variants and teething issues with the vaccine rollout, risks may reappear quickly and can flip market sentiment.
Medium to longer-term considerations includes the prospect of a structurally weakening dollar, which remains at an overvalued level. A weaker dollar will have an impact on the global economy in several ways but will also have varying impacts on regional equity markets. The US market is the most domestically biased (measured by domestic currency revenue) by virtue of the size of the economy. Further dollar weakness would present a headwind to US equities, reversing the tailwind that has been present for many years.
Finally, the importance of China to the global economy and markets. China has been the key driver of global economic growth contributing around a third to total global growth over the last decade. Any weakness in China would therefore be felt across all markets. With demographic and geopolitical headwinds, the direction of travel is for gradually slowing growth, although there is also the risk of more rapid deceleration.
As discussed previously, it is likely that traditional valuation metrics such as P/E ratios are not going to be as effective measures in the current environment. The earnings component has taken a significant hit this year, and there is the potential for losses in many companies and sectors. This is going to make PE ratios look high as investors are rightfully looking at 2021/22 expected earnings.
There have been further upward revisions in earnings for 2021, and 2020 earnings exceeded expectations as they were in April last year. The latest analyst estimates are up 3.3% and growth in 2022 is expected to be 15% in 2021. The potential for exceptional upward revisions over the coming quarters is weakening as the current estimates are increasingly factoring in the reopening of economies. However, it is reasonable to expect that there is still some scope for higher earnings.
While there is positivity around earnings, this has been reflected in share prices, which continue to trade at high multiples by historical standards. However, while the market has risen, earnings expectations kept pace, leading to no further multiple expansion. Nevertheless, we need to be cognisant of the lessening potential for upward earnings decisions, making higher multiples less palatable than before.
As discussed previously we have not looked to over-interpret index level price to book data, as it is increasingly difficult to analyse, particularly for tech-heavy markets such as the US. However, comparisons of recent price to book values may be another tool to assess the “cheapness” of markets. Book values should be more stable than earnings through this crisis, and in theory, should provide a better indication of the long-term value of companies. Nevertheless, there is a high chance that some companies (eg. the Energy sector) will be compelled to write down book values in the current environment. Price to book values has been relatively stable over the quarter, albeit at a high level.
In line with the last quarter, overall, it is difficult to argue that the market is cheap, however, there is a greater than usual uncertainty in the outlook for earnings and as we do believe that there is scope for earnings revisions higher, making the P/E multiple is easier to digest for next year. The valuation of equities also needs to be considered in light of the very low level of bond yields (both government and credit), as well as the continuing central bank and government support. With large amounts of money searching for returns, the equity market may continue to find buyers at higher prices, as long as there are no significant negative changes to the current pathway out of the pandemic.