We sound a note of caution as well. September and October are typically months of increased volatility and often corrective action. The S&P has fallen by an average of nearly 1% in September in the past 20 years as investors often cash out on underperforming stocks before the end of the third quarter. October is also historically a difficult month, coinciding with the anniversary of market crashes in 1929, 1987, 2008 and, most recently, the downturn in 2018. We are also overdue a pullback. The market has gone 10 months without a 5% drop in stocks, marking only the fifth time that this has happened in 20 years.
But a correction, even a 10% downturn, is never usually the end of a bull market, as long as solid fundamentals are in place. Since World War II, following intra-year corrections, markets have taken four months on average to regain their former highs. What’s more, data back to 1928 shows that gains of 20% or more in one year – such as we have experienced in 2021 – have happened 25% of the time. In the majority of cases, the following year has also delivered a gain.
We remain positive over the medium term and, looking forward to 2022, believe that this is still a good environment for shares, whether in public or private markets, though the magnitude of gains will likely reduce. We would also not be surprised if some consolidation or pullback was to happen and see plenty of factors to worry about, any one of which or in combination could set the stage for market weakness.
However, as highlighted below, we think that economic growth, earnings and corporate dynamicism will remain strong and will continue to support risk assets with a medium-term view. Therefore, in our view, long-term holders should remain invested for the long term, and not try to time markets. Moreover, a diversified portfolio across different asset classes can help cushion any near-term declines.
Worry Beads Aplenty, but Positive Trajectories as well
Investors worry about growth ahead.
The economic recovery has lost some momentum recently as the surge in Covid-19 cases and lingering supply constraints have made businesses and consumers more hesitant. And, while the link between Covid cases and deaths has been dramatically reduced (with increased vaccinations rates), we see evidence that spikes in cases are affecting economic data. The recent disappointing job numbers in the US is a good case in point. Economists were expecting more than 728,000 new jobs but the payrolls report showed just 235,000 jobs last month, compared to 1.1 million posted in July. These numbers have come on the back of recent weaker-than-expected retail sales in the US and the Eurozone, and softer manufacturing, retail sales and export data in China. These weaknesses are in large part due to the Delta variant.
Meanwhile, weather-related disasters have continued, with fires in California and Greece, floods in China and Germany and hurricanes such as Ida in New Orleans, to name just a few. The FT reports that developed nations have incurred $3.6tn in economic losses from severe weather events over the past five decades. The latest example is that the estimated cost of Hurricane Ida could be as high as $80bn. These weather disasters not only cost money but cause economic growth to slow in the affected areas. The frequency of these events remains a risk to growth.
Peak everything is also an investor concern. In other words, the level of fiscal and monetary accommodation, and thus the level of economic and earnings growth, will be not as strong as it has been in 2020 and 2021. This is natural as the first year of recovery usually coincides with highest level of GDP and earnings growth, particularly in comparison to a prior, weak year. The level of fiscal and monetary stimulus, particularly income subsidies, is also waning.
So, for the most part we agree with these concerns. Between Covid and natural disasters, the path of economic recovery will not be linear and we should continue to expect growth interruptions along the way. But on the positive side, while we expect economic growth to slow in 2022, we still expect it to be in the range of 3.5% to 4.0% next year, which compares favourably to 2.3%, the average level of growth in the developed world coming out of the global financial crisis. Moreover, we think the recent softening in economic activity represents more of a pause rather than a derailment.
It should be noted that near-term risks to growth mean that Central Banks are likely to remain cautious in withdrawing support, even if they begin to reduce the level of bond buying, so-called ‘tapering’, towards the end of this year. They will not want to undermine a recovery when the Delta outbreak still exists. In any event, tapering is not the same as raising interest rates, which the chair of the Federal Reserve has signalled is not likely until 2023 at the earliest.
Looking forward to 2022, the catalysts to solid growth are numerous. We see a positive trajectory for strong consumption, with pent-up demand for services and travel experiences. For example, consumers in the US are sitting on more than $3.4 trillion of excess cash, according to Longview Economics. Strong housing and stock market price increases have also contributed to a better sense of economic wealth. Companies are seeing good growth, as evidenced by recent earning numbers, while inventories are at record lows. Rebuilding inventory levels is expected to contribute positively to growth next year. Cornerstone Macro expects US corporate investment spending to rise by 9%, and to almost double as a percent of GDP in 2022, as companies invest to meet rising demand and to remain relevant in a world of increased change and disruption.
Climate-related spending is also likely to increase; we expect there to be renewed government commitment to investing in green and renewable projects as we approach Cop26 – and beyond. Meanwhile, governments in the larger economies are grappling with the right formula for continued fiscal spend; the US will likely lead the way and pass a sizeable infrastructure package before year end. China and Europe have also prioritised green, digital and technology spend.
Therefore, we see a range of economic factors contributing to solid economic and earnings growth in 2022 and beyond.
The Inflation Debate
Much has been written about the risk of runaway inflation based on too much stimulus in recovering post-pandemic economies. Recent inflation prints have been high, with recent year-on-year inflation numbers at more than 5% in the US and 3% in Europe, which are some of the highest levels we have seen in more than a decade. Were these levels to persist, Central Banks around the world would need to tighten sooner than expected. History has shown that valuation multiples come under pressure when interest rates rise above 4% for a sustainable period.
However, we are nowhere near that level and believe that recent outsized increases in inflation are largely due to transitory factors. As economies reopen, demand has far outpaced the ability of certain supply chains to keep up, causing near-term bottlenecks and price increases. In some instances, like the recent closing of the world’s third-largest port in China, because of an increase in Covid cases and flooding, has exacerbated the trend. The price of moving a 40ft container from China to the US west coast has jumped to almost $20,000 – more than 500% from a year ago. However, as the port reopens, and supply catches up, shipping rates are expected to normalise. We have now seen other supply related price increases (used car and lumber prices) begin to moderate.
What’s more, unemployment rates in large parts of the developed world are still above pre-pandemic levels. While demand for workers in some sectors is red hot (restaurants, lorry drivers), overall the existence of surplus labour and rising levels of productivity, on the back of increased corporate investment, is likely to keep inflation within Central Bank targets of 2%, on a consistent basis.
Finally, investors worry about rising valuations and certainly the US market at 20x earnings is trading higher than its historical average of 18x. However, it should be noted that while the market is up strongly year to date, the actual level of valuation is the same as at the end of December 2020, despite the move higher of more than 20%.
The reason? Strong earnings. Recent gains are underpinned by robust earnings growth. More than 90% of US companies, for example, have now reported Q2 results and companies have again beat earnings. Aggregate corporate profits are up nearly 90% from year-ago levels and earnings are now nearly 30% higher than pre-pandemic levels. Indeed, S&P 500 profit margins hit a multi-decade high in the quarter at close to 14%. Sales and earnings results have now surpassed consensus expectations for five straight quarters.
Exceptional growth in earnings is not just limited to the US, with European earnings currently tracking a growth rate of roughly 249% from the same time last year, when Covid shutdowns drove the euro area’s economy into its sharpest contraction on record. The percent of European companies that beat analyst’s earnings estimates also hit a five year high in the second quarter, according to data provider FactSet.
At the start of the year, the S&P 500 was trading at 22.7x— this measure has moderated to 21.1x. Analysts at both Goldman Sachs and Credit Suisse have recently boosted their 12-month projections for the S&P 500 on the back of upward revisions in earnings growth.
We see reasons to be cautious near term. For investors needing capital from their portfolio soon, trimming now into market strength is never a bad thing. However, for long-term investors, we recommend staying put and riding out any volatility ahead. While the trajectory of growth will be lower next year, expectations are still for above-average economic growth in 2022. This bodes well for continued gains in earnings ahead.
We also think that shareholder-friendly activities will support risk assets. With large amounts of cash on corporate balance sheets, companies are incentivised to raise dividends and/or engage in stock buy-backs. We have seen record M&A volumes this year. M&A tends to correlate with positive market action as consolidations can allow for either faster top-line growth or better cost synergies. In either case, M&A can drive an earnings improvement.
Moreover, we are seeing high levels of corporate dynamicism. Trends in digitalisation and innovation continue apace as new business models emerge that are taking advantage of increasing internet penetration, advances in 5G, artificial intelligence, machine learning and moves to the cloud. The pace of change is accelerating; in the words of Cathie Woods of ARK Invest, ‘converging S curves’ lead to accelerated disruption and strong growth for companies that can benefit.
In this environment we continue to favour the US, with its large representation of secular growth themes and emerging growth companies in both public and private markets. The US is still superior in terms of margins and profitability, with companies having grown earnings by 100% more than the rest of the world during the past decade. Europe also offers a range of excellent companies that continue to deliver strong earnings at an attractive price.
In Asia and China, these markets have been poorer relative performers year-to-date. Recently, China has gone from almost laissez-faire in regulation to highly interventionist in the short space of a few months. Near term, these unpredictable government moves will continue to unnerve investors. Of course, China is not alone in increasing regulation in the interests of fairer competition; however, it has been the ‘heavy handed’ nature which has dampened sentiment. At some point the rules of engagement will be clearer and companies will adapt to the new norm.
China still has the second-largest equity market and the second-largest bond market in the world and continues to rival the US in size and commitment to leading technologies, digitalisation and innovation. We are positioned with managers whose investment style is to align with government protocols and social priorities. Hence, while increases in regulation will weigh on sentiment, we think that the Asian markets, and China in particular, remain long-term sources of secular growth and return.
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