Equities: beware peak momentum

Key points:

• Upbeat quarterly earnings as equities hit fresh highs
• But with momentum in earnings, economic growth and policy stimuli measures seemingly slowing, the road ahead may be bumpier
• Still, light investors positioning and a delayed recovery in emerging markets could provide some support
• It may be time to reduce cyclical exposure to more neutral levels and focus on quality rather than value stocks
• Portfolio diversification and active management appeals in such uncertain times.

Initial earnings results for the three months to March support the “bull case” for US equities this year. The consensus for full-year 2021 earnings per share (EPS) estimates hit $180 from $170 for the S&P 500. This suggests that the index could end the year at around 4,200, a 12-month gain of 11.8%, given the strong earnings backdrop.

Caution is the watchword

Despite the seemingly positive outlook for equities, gains may be more difficult as positive surprises look like being harder to come by. Equities tend to respond to momentum, or the rate of change, rather than to the absolute level of a stock or index. Momentum might slow in coming months on several fronts as a series of “peaks”, such as for earnings and global economic growth, are reached. While this is not necessarily the cue for a financial market correction, it will probably limit short-term upside.

Peak economic momentum

Economic momentum is the first of the peaks on the horizon. The two largest economies – China and the US – look particularly vulnerable.

Chinese gross domestic product leapt 18.3% year-on-year in the three months to March. That said, comparison was with the slide in output seen in the first quarter of last year, as the pandemic hit. Indeed, the quarter-on-quarter growth rate slowed to 0.6%, pointing to a decelerating recovery.

Similarly, in the US, the ISM services index of activity jumped to a record level of 63.7 in March as the economy started reopening, suggesting a buoyant economy. While more strength is likely in the next couple of months, the rate of progress will slow as economic life returns to pre-coronavirus levels.

Peak monetary easing

Central banks’ accommodative policies have helped drive the bull run in equities seen since March 2020. By pumping a record amount of liquidity into the system, and keeping interest rates low, monetary policy boosted valuations and investors’ risk appetite. However, at this stage, and bar a resurging pandemic, it’s hard to imagine central banks becoming more dovish soon. While tightening policy may be at least a few quarters away, the liquidity impulse is likely to slow.

Peak fiscal support

Just like monetary support, fiscal stimuli may have peaked. In America, investors better understand the size and scope of the new Democrat administration’s policy plans, including for infrastructure and climate change initiatives. Importantly, additional government spending isn’t unequivocally positive for equity valuations anymore, given spending offsets in the form of higher tax rates.

In a similar vein, the UK government set a precedent this year when announcing inflated corporate tax rates starting in 2023.

Earnings growth looking peaky

There seems little reason to expect company earnings to stop growing, including in the short term, underpinning one of the reasons for investing in equities. In the US, 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 will likely decelerate from the three months to September. This momentum shift might test valuations.

Peak watching: vaccinations and inflation

In addition to economic momentum, earnings growth, government spending or central bank support and earnings growth mentioned already, two more variables may peak this year. First, the marginal advantages of more vaccinations, especially in the developed world, will probably fall as herd immunity is reached. Second, inflationary pressures may max out in the summer. In turn, this hints at a recovery that is losing steam.

Optimism prevails for now

While the best of the post-slump recovery may be over, other factors may strengthen. First, this year’s generally upbeat investor sentiment and strong equity inflows have not been backed up by positioning, which still appears relatively light. Second, while China, the US and the UK may have, or be approaching being, fully recovered, progress on continental Europe and most emerging markets lags. This twin-speed recovery may help drive the next leg of the recovery.

Finally, parts of the economy will likely grow strongly, irrespective of COVID-19 developments. This seems particularly so for sectors linked to climate change, new technologies (such as artificial intelligence, cloud computing or automation) and healthcare.

Stay invested and diversified

The outlook remains constructive for long-term investors. Similarly, keeping diversified, multi-asset portfolios while managing them actively appeals at such an uncertain time.

Given the peaks ahead this year, as discussed above, investors might want to reduce any cyclical exposure to more neutral levels. This, combined with a focus on investing in quality companies, is likely to help portfolios weather what is likely to be a bumpier road ahead.

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