Recently, US bond yields plunged from their highs to levels not seen since early February. Equity markets hit record highs still. Volatility increased. The Q2 results season is under way and evidence suggests that companies need net beats on sales and margins and/or a raised guidance to get rewarded by the market. “Have we already seen most of the market’s gains?” is a fair question to ask these days.
The key metric to watch is the Purchasing Managers’ Index (PMI). It’s the best gauge of the economy, as it is a leading indicator for the expected quarterly GDP. Buying equities when PMIs are at a low point and are set to rise is key. That turning point occurred in November last year, fostered by the vaccination news and by the prospect of record fiscal support measures, especially in the US. Hence “Roaring 20s Revival” expectations grabbed the headlines and the reflation trade set in.
Today, the PMI is at a 20-year high. Global growth has probably peaked at a very high level in Q2. The engine has been running red hot for two quarters. Equities typically outperform bonds with global PMIs above 50. A cooling-off period could be imminent. Hence, the pace at which equities will outperform will diminish. But since growth is still lower versus pre-Covid levels, there is still fuel in the tank.
The equity risk premium, especially in Europe, is still at levels that are not consistent with a bear market. They suggest Europe should outperform the US going forward. There are elements that can put a brake on the US recovery: a gradually faltering impact of fiscal stimulus, a pull-back of consumption due to the spreading of the delta variant, … Other than in the US where everybody received a cheque (including people who did not need it), in Europe, measures mainly aimed at safeguarding the disposable income of households hit by the pandemic. Europe’s support will have a more lasting impact. And the EU recovery fund’s impact is still to come. Growth will remain strong, but the growth pace will moderate from here, as reflected by the drop in bond yields and inflation expectations.
Bonds were oversold and yields have pulled back sharply due to peak markets and growth concerns related to the delta variant risk. They are not yet at fair value, as the bigger picture favours higher yields. Inflationary pressure and economic activity are consistent with higher yields. Do I expect them to be much higher? No. Central banks keep their foot on the brake and remain dovish. Financing conditions remain very easy, with tight credit spreads and real rates that are too low to be positioned for an end-of-cycle dynamic. Neither fiscal nor monetary policy support will be removed quicker than warranted. But as recovery progresses and economies move towards a self-sustaining path, it is only natural for policymakers to start thinking about exit strategies. Equity markets will discount this proactively, taking valuations lower.
Valuation is another pain point. Valuations are not cheap and already discount a lot of hope. With peak growth behind us, we should expect that valuations would de-rate with better earnings. Also, higher real rates and more hawkish central banks would pressure the multiples. The Q2 earnings season has started strongly with a less outspoken net beat than the record beat of Q1. Year-to-date, earnings revisions have moved up 15% (+6% at Q1). Especially in Europe analyst expectations are at record highs. We are half way in the Q2 earnings season, but overall updated guidance indicates a more challenging H2 due to supply chain disruptions and higher raw material prices. It has become a “travel and arrival” story. Most probably the revisions cycle will slow from here. Manufacturers run at full capacity but will hit a wall due to inadequate inventories and a shortage of skilled labour. They can’t meet strong demand. In order to protect margins, they need to invest in improved efficiency. Hence capex intentions remain strong and will be a determining factor for positive performance of industrials. Tech is less related to the macro picture, but I expect a structural outperformance for tech. Europe is very sensitive to the global industrial recovery. But the next leg in the recovery needs to come from consumers willing to fully engage in the services business.
