03 Sep 2021
Recent Purchasing Managers’ Indices (PMI) data has dropped off the very strong numbers we have seen for most of this year and macroeconomic data surprises have turned negative, so why have equity markets charged higher?
There is an abundance of challenges in the economic backdrop; talk of tapering from central banks, government deficits continue to pile higher, inflation is creeping up past target levels, and unemployment remains stubbornly high. Yet markets have continued upwards, with the S&P500 at double the value of its March 2020 low. There must be something driving markets higher, and a closer inspection of earnings season provides a lot of colour.
Chart 1: Change in World MSCI equity index, earnings per share (EPS), and price-to-earnings (P/E)
Source: Bloomberg, BMO Global Asset Management, as at 26-Aug-21
Chart 1 shows that the continued bull market in equities mirrors the meteoric rise in earnings. Over the past year, stock prices have struggled to keep pace with improving earnings projections, leading to forward Price / Earnings (P/E) multiple declines. Valuations have fallen from their highs but still remain elevated relative to long-term averages due to low rates and tight spreads.
Year-on-year earnings growth for the latest quarterly results has been strong globally, not just in the US, with Europe, Japan and emerging markets all recording very strong growth. Sectors with the highest earnings growth are cyclically oriented such as Industrials, Consumer Discretionary, Materials and Financials. Global earnings are already significantly above pre-pandemic levels with year-on-year earnings growth at highest levels in a decade, benefitting from base effects. Estimates for Europe are still below their pre-pandemic levels but are rising. This has prompted analysts to upgrade forecasts across the board for next quarter’s earnings season. Markets look forward and it is these increases in analyst forecasts that have driven equity markets higher.
US S&P 500 beats have been extremely strong for a fifth straight quarter, but the overall market reaction immediately following earnings results disproportionately punished misses more so than it rewarded beats. Investors may have become accustomed to large surprises while also worrying about the Delta variant, central bank tapering, peak earnings growth and margins.
Chart 2: S&P 500 Quarterly EPS Surprise
Source: Bloomberg, BMO Global Asset Management, as at 26-Aug-21
Yes, there remain the economic challenges as mentioned above, as well as specific concerns for companies around increasing raw material costs and labour costs. However, it is earnings growth that drives profit margins, not input costs, and this supports the market’s optimism. Companies are also able to use tools to mitigate the pressure from rising input prices, such as passing price increases on to end consumers or increasing productivity.
As multi-asset investors with a longer-term investment horizon, the equity market’s optimism does not seem misplaced. The removal of central bank asset purchases is much more of a challenge for bond markets. And this leads us to remain positive on equities, both on a fundamental basis and also from a relative perspective to other asset classes. Within equities, we have a preference for the markets in the US and Europe.
We believe an active approach makes sense for multi-asset portfolios, both in terms of tactically dialling up or down regional allocations within asset classes, and also from a stock picking perspective. Whilst short-term markets can be driven by media ‘noise’, longer-term performance tends to be more in-line with fundamentals, and so it makes sense to use an active bottom-up approach to uncover the companies that have the qualities to outperform their peers, as well as identifying those businesses who are at risk from the changing backdrop, whether that be regulation, taxation or supply constraints.
Risk warnings
Please note that this is a marketing communication and does not constitute investment advice or a recommendation to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. Views are held at the time of preparation.
Past performance is not a guide to future performance. Stock market and currency movements mean the value of investments and the income from them can go down as well as up and you may not get back the original
amount invested.