The major central banks continue to believe that the bulk of the rise will be temporary and are still intent on tightening policy only gradually. The Fed has effectively brought forward its forecast for the first rate rise but only to 2023 from 2024. As for tapering its QE-related bond purchases, this still looks set to start early next year.
In the UK, the BoE has turned a bit more hawkish and the QE programme is due to finish at year-end. However, the first rate increase still looks unlikely to occur until 2023. In the Eurozone, meanwhile, the ECB has switched from targeting inflation of below but close to 2% to a symmetric 2%. Rates there now look unlikely to be raised before 2024 at the earliest. A key question, therefore, is how aggressively central banks might react if higher inflation is more persistent than they currently expect.
Equity markets have continued to trend higher in recent months with global equities now up some 15% year-to-date in local currency terms. The driving force behind the gains has remained corporate earnings which have rebounded considerably faster than expected.
In the US, the Q2 reporting season just finishing looks set to see earnings up over 90% from the lows of a year ago. For the fourth quarter running, results are coming in well above expectations. At a global level, earnings
should be a sizeable 25% higher this year than pandemic in 2019.
Earnings should continue to drive further gains in markets, although the upside is limited as growth will slow substantially over the coming year. Policy will also become less supportive, with central banks taking the first steps to scale back their massive stimulus. Continuing high levels of investor cash will compensate but only to some extent.
Valuations are likely to be another limiting factor as they may come under some modest downward pressure if bond yields head higher again. Indeed, the forward looking price-earnings (P/E) ratio has already fallen back from last year’s 20 year high of 20-21x to 18-19x.
Within equity markets, the major factor driving both regional and sector outperformance has been the rotation between expensive ‘growth’ stocks and cheap ‘value’ stocks. After years of marked underperformance, value stocks saw a burst of outperformance starting last November on the back of vaccine optimism. However, this has gone into reverse over the last couple of months.
We believe value stocks should come back into favour again. Strong economic growth, rising bond yields and an abnormally large valuation gap between growth and value stocks are all conducive to a renewed rotation later this year.
The outlook looks considerably worse for fixed income than for equities. Government bond yields have fallen significantly since mid-May, unwinding much of their rise in Q1. This decline has occurred despite inflation surprising significantly on the upside.
Various technical factors have driven the bulk of the drop in yields although worries over the Delta variant have also contributed. Just as yields overshot on the upside earlier in the year, we believe they have now done so on the downside and expect government bond yields to head higher again over coming months.
