Equity bulls in charge

Key points:

• With elevated valuations, the risk-reward for equities seems balanced
• The fair value of equities seems closer to our bull case scenario for 2021 (in the 3,900-4,000 range on the S&P 500)
• A surge in inflation appears to be the biggest downside risk facing investors. The withdrawal of fiscal and monetary stimulus may be another such risk
• With so much pent-up demand, a stronger and quicker recovery than expected is among the top upside risks this year
• A more active approach to investing seems called for, with wider dispersion in returns likely, plus a focus on “quality” companies.

After rising by 6% in the first two months of the year, global equities have given up some gains so far in March. Given possible worrying surprises, the risk-reward remains balanced but the road ahead seems likely to be bumpy.

The earnings being reported for the final three months of last year have been even stronger than anticipated. With more than 80% of companies surpassing the consensus’ forecast in the US, fourth-quarter earnings growth is on track to reach 3.5% versus an 8% decline expected initially. This is an amazing outcome given that COVID-19 did not affect data in the fourth-quarter in 2019. Furthermore, expected earnings for the following twelve months are picking up.

In Europe, the picture is more mixed and Q4 earnings have contracted by at least 15%. Most of this difference can be explained by the divergence in index composition with American peers, Europe being much more exposed to the energy and financial sectors and less to technology.

Bull market case?

With much stronger-than-expected Q4 earnings, our numbers for this year have a more solid base on which to grow. As a result, equity markets’ fair value has moved a few percentage points higher, in our opinion, and closer to our bull case scenario for 2021 (in the 3,900-4,000 range on the S&P 500).

This scenario assumes recovery through the year, backed up by accommodative monetary and fiscal policies and a successful COVID-19 vaccination campaign in the most of the developed world.

Potential downside risks

The outcome may disappoint if any of the above assumptions fail to deliver. Top of the “wall of worry” is inflation. Indeed, the topic has attracted much attention in the last few months. The combination of base effects, recovery, higher commodity prices and stress in some value chains (semiconductors in particular) point to a potentially sharp increase in prices.

While a temporary surge in inflation could be managed, the real risk lies with a sustained rise in prices. Though moderate inflation (as opposed to deflation risk) may be welcome, persisting negative interest rates in Europe and very low ones in the US do not seem appropriate for a world where 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 a much tighter stance, possibly putting pressure on equity valuations.

Fiscal pressures

The key reason why economies and markets have been able to recover so quickly from the pandemic shock is the unparalleled 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.

When stimulus is reversed, the real impact of the pandemic could be felt. The result would likely be a surge in bankruptcies, a spike in unemployment rate and a much bleaker outlook for companies. This would compromise expectations for a strong earnings recovery and see asset prices drop. Such a miscalculation might be met with additional monetary support, eventually, but it would certainly leave a mark.

And on the upside

Much positive news already seems to be discounted by the market. That said, two particular upside risks are worth highlighting.

The first one relies on even stronger-than-anticipated earnings growth. As January’s US retail sales figures suggested, pent-up demand might be significantly higher than initially thought.

The second upside risk could be a faster-than-expected return to normal. 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 of the most affected areas of the economy (travel and leisure in particular) to recover ahead of plan.

Getting active

Although the upside at the index level may be limited, investment opportunities can be found. Indeed, with elevated expectations and limited visibility, significant dispersion at both the sector and the stock level seems likely.

Wider dispersion in returns calls for a more active approach to investing, using stock picking to unearth alpha in a world were beta might be less relevant. Our focus remains on “quality” investing, favouring resilient free cash flow generation and attractive medium-term growth prospects.

In addition, properly diversified portfolios can help to mitigate the effects of not just known risks by also potentially extreme, “black swan”, events when they occur. This is why adopting a balanced approach when building portfolios seems preferable.

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