Published by Edison Investment Research

ILLUMINATIONEquity strategy and market outlook

September 2021

Edison Insight | 30 September 2021 1

Global perspectives: Cautious on equities

The economic cycle continues to evolve and investors should position portfolios accordingly. The advent of mass COVID-19 vaccination programmes in developed nations combined with enormous monetary and stimulus packages dating from 2020 have created the conditions for a sharp closing of output gaps. A slower pace of GDP growth should now be expected. We note purchasing managers’ indices (PMI) have peaked over the summer in both the eurozone and the United States.

Financial markets are contending with both fiscal and monetary headwinds. Developed market fiscal policy will be progressively tightened during 2022 having remained loose for the duration of 2021 at the same time as monetary policy is tightened. Market volatility has risen in recent weeks as policymakers negotiate their first steps away from COVID-19 support towards more neutral settings, consistent with the closing of output gaps in developed market economies.

Rising earnings forecasts for 2021 have been the fundamental support behind the market rally. However, during the past month momentum in profits forecasts has come to a near-standstill with most global sectors seeing no increase in forecasts during the past four weeks.

Inflation and inflation uncertainty are key to the outlook for asset prices. With the notable exception of Japan, developed market core consumer price indices have surged above long-term trends. Anecdotal evidence of shortages has become endemic, affecting industries as diverse as shipping, semiconductors and agriculture. Rising survey based inflation will need to be reconciled with currently benign market-implied inflation measures.

Equity investors may be of the view that they are partially hedged against higher inflation as equity represents a claim on the nominal future profits stream. This is true but should not give rise to complacency. At times of high inflation equity valuations have historically tended to suffer from higher inflation uncertainty, which increases the required rate of return due to an increase in the equity risk premium.

Since last month we have moved to a cautious position on global equities as high valuations are now inconsistent with evidence of a slowing of economic momentum and the imminent prospect of tighter monetary conditions. On a global basis both corporate credit spreads and our estimate of the global equity risk premium are close to 17-year lows.

Analyst Alastair George +44 (0)20 3077 5700 institutional@edisongroup.com

Edison Insight | 30 September 2021 2

Slowing growth and high valuations drive cautious view

The economic decoupling from the COVID-19 pandemic has been re-emphasised in recent weeks. Vaccinations have remained effective in maintaining a relatively low level of hospital admissions, even as daily case numbers indicate ‘delta’ continues to spread. However, epidemiologists in the UK at least are struggling to explain why case numbers are not accelerating as autumn approaches. It may be that the combination of vaccinations for older adults plus evidence from Public Health England of natural infection for up to 30% of those aged between 18–29 means the long-sought status of herd immunity is close.

In developed markets, the advent of vaccines in combination with earlier monetary and fiscal stimulus has created the conditions for an exceptionally strong period of GDP growth. This welcome development also implies that the anticipated ‘scarring’ of the global economy due to COVID-19 shutdowns appears to have been largely avoided. Nevertheless, the rapid closing of output gaps in recent quarters means that this intense period of growth will soon come to an end.

For investors, it is the rate of change or direction of growth rather than the level which is arguably the more relevant factor for portfolios in the short-term. We believe we are coming to the end of the period of supercharged growth, even as current activity indicators remain strong. We note the softening of PMI indices in both the United States and eurozone over the summer, which indicate that a slowdown may already be underway. We believe this may be the start of a new, more subdued trend which will persist into 2022.

Exhibit 1: Narrowing output gaps close the window for extraordinary policies

Source: OECD Economic Outlook May 2021, 30 September 2021

The extent of COVID-19 fiscal support has been in some respects a ‘surprise’ in comparison to the relatively tight fiscal policy which followed the global financial crisis of 2008. ‘Austerity’ policies in hindsight appeared to achieve little except slower growth and lower interest rates.

Regardless of the relative merits of this more expansionary fiscal support, IMF forecasts show that the remarkable level of fiscal spending growth during 2020 which has been maintained during 2021 is due to contract sharply next year in G7 nations. These forecasts highlight the challenge in front of national economies to maintain growth while weaning themselves from emergency COVID-19 fiscal support.

-14.00-12.00-10.00-8.00-6.00-4.00-2.000.002.004.00

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

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Edison Insight | 30 September 2021 3

Exhibit 2: G7 fiscal contraction forecast during 2022

Source: International Monetary Fund

Earnings estimates have been a key fundamental support for rising equity markets during 2021 and the increase in expectations for profits has now exceeded the initial COVID-19 related decline in 2020. 2021 earnings estimates are now at new record levels and 7% above those prevailing prior to the pandemic. We believe few investors would have been so bold to predict that a pandemic, which created one of the sharpest declines in economic output ever recorded, would have proved to be a net positive for the corporate sector.

Nevertheless, it is the rate of change of forecasts to which markets are more sensitive and we have observed that most global sectors have seen no upgrades in the past month, compared to near-universal upgrades over the prior three months. This loss of earnings momentum is consistent with the lack of progress made by global markets and increase in volatility seen towards the end of the summer period.

Inflation and inflation uncertainty are a risk to the outlook While the period of supercharged growth is proving to be transient, we are becoming increasingly concerned that inflation is rising rather faster than monetary policymakers might have originally wished. The US Fed has for example raised the forecast for 2021 US core inflation in its Summary of Economic Projections three times so far this year, from 1.8% to 3.7%. As a result, Fed policymakers’ interest rate expectations are now on a rising trend for 2022 and 2023, suggesting that any ‘slack’ in policy resulting from the concept of average inflation targeting has now been taken up. The risk is that further upside surprises to inflation will now lead to a one-for-one policy response.

Exhibit 3: Rising US inflation and survey-based inflation expectations not yet reflected in US bond yields

Source: Refinitiv, Federal Reserve Bank of New York

While central banks have pointed to market-based implied measures of inflation being well-contained, consumer-based surveys in both the United States and the eurozone do not suggest that consumers are as sanguine. Survey-based inflation measures have been rising rapidly during

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Edison Insight | 30 September 2021 4

2021, especially among lower-income consumers which are likely to have been affected to a greater extent by rising food and energy costs. Political risks are rising, as evidenced by the recent panic buying of fuel in the UK but also by the relatively larger number of voters affected by rising living costs. Anecdotal evidence of inflation is also widely spread across industries, with reports of actual shortages or rapidly rising prices for semiconductors, foodstuffs, building products, shipping, natural gas and fertiliser.

Equity investors may be of the view that compared to government bonds they are partially hedged against higher inflation as equity represents a claim on the nominal future profits stream. This is true but should not give rise to complacency. At times of high inflation equity valuations have historically tended to suffer from higher inflation uncertainty which increases the required rate of return due to an increase in the equity risk premium.

Global risk premium close to 17-year lows We have previously observed that global equity valuations are at levels not seen since immediately prior to the 2008 financial crisis on a price/book basis. To add to the weight of evidence on valuations we have now estimated the global equity risk premium based on aggregating contemporaneous forecasts for medium-term growth for each stock in the world index.

We find that at present the risk premium for global equities has been relatively stable at 3% for much of this century but has recently fallen to close to a 17-year low. The estimated equity risk premium is closely correlated to corporate credit spreads, which are similarly close to their lows for the same period.

Unlike P/E or price/book measures, estimating the equity risk premium using forward-looking data accounts for the very benign period of revenue growth forecast over the coming three years. Globally, revenue growth is currently forecast to be several percentage points above its longer-term average of 5–6%. While this could be considered comforting, to the contrary in our view it raises questions about the level of optimism currently embedded in consensus earnings forecasts. At the very least, this level of confidence in the future would appear to reduce the scope for further positive surprises from the corporate sector. We would be more comfortable if aggregate forecast revenue growth was closer to consensus forecast nominal world GDP growth over the longer-term.

Exhibit 4: Both global equity risk premium and corporate credit spreads close to 17-year lows

Source: Refinitiv, Edison models and calculations

Central banks on the road to policy tightening Therefore, should central banks become pushed to act against rising inflation expectations, there is clearly potential for markets to move lower based on currently high valuations and the currently low equity risk premium. We note that the ECB has started to taper its Pandemic Emergency Purchase Programme (PEPP) with several policymakers becoming increasingly vocal on the upside risks to inflation.

0%1%2%3%4%5%6%7%8%9%

2004 2007 2010 2013 2016 2019Equity risk premium US investment grade credit spread

Edison Insight | 30 September 2021 5

Despite the increased ‘policy space’ created by average inflation targeting, the US Fed appears to be reaching the limits of its new policy already. It has signalled the start of the tapering of its quantitative easing programme later in the year, a process that Fed Chair Powell believes will be complete by mid-2022.The first US interest rate increase is now projected to be in place by the end of 2022 rather than some time in 2023. The steady rise in long-term government bond yields during September suggests that central banks are perhaps on modestly more hawkish tracks than investors originally expected. Furthermore, in our view the risk remains that any further unanticipated increase in US inflation could accelerate this pace of policy normalisation.

Conclusion

We believe investors should be maintaining a cautious approach to equities at present, especially in those sectors and markets which are trading well above long-term valuation averages. Globally, equity valuations remain extended on a price/book and forward P/E basis. Furthermore, our estimates of the global equity risk premium suggest investors are currently tolerating a meaningfully lower rate of return on equity portfolios than usual, even after accounting for above-average forecast growth for the three-year period immediately ahead.

We remain underweight on global bonds despite the recent increase in yields. Current yields still do not appear to reflect rising inflation or inflation uncertainty, nor the Fed’s new-found determination to ensure an average rate of inflation close to target in the medium term. These factors suggest that at current yields global bonds could offer limited or even no protection as the global economy slows as we expect during the autumn. With corporate credit spreads still tight, the optimal shift in portfolios may be to ‘none of the above’ which is a tactical allocation to cash and to reduce portfolio ‘beta’. We expect for many investors this may be emotionally the hardest move to consider, after such a strong run in risk assets.

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