Markets eye a new phase of the post-pandemic recovery

Economic growth may have passed its high point for this cycle, and earnings growth may have peaked, too.

“Judging by the slew of half-time investment outlooks being released at the moment, many investors and strategists are asking how far equity markets can run given their impressive gains over the past 16 months,” says Michael Mackenzie in the Financial Times. That’s no surprise, since there are plenty of uncertainties to ponder.

Policymakers are likely to scale back fiscal and monetary support, which could mean a slower economic recovery and weaker earnings growth. Taxes may start to rise to begin paying for the extraordinary level of government spending during the pandemic. Investors remain fixated on inflation and whether recent trends for higher prices are transitory: if they are not, interest rates may need to rise, which could mean a bumpy ride for markets. All this complicates any forecasts for which types of stocks – such as cheap value, expensive growth, cyclical recovery plays or high-quality defensives – are likely to do best in the months ahead.

However, there are clear signs that we’ve passed the part of the cycle “in which risk assets are embraced almost without discrimination”, says Buttonwood in The Economist. Key indicators such as the output and orders components of the US purchasing managers’ index (PMI) appear to have peaked in May, suggesting economic growth may have passed its high point for this cycle, at least in America.

That in turn implies that earnings growth may have peaked, which would be a headwind for a market that already trades on a relatively high valuation. “Markets are forward looking. They now have less to look forward to.”

Lessons from recent history

Of course, these are exceptional times, says Andrew Sheets of Morgan Stanley. “The global economy saw the largest collapse in recorded history… what followed was the largest global fiscal easing, the largest monetary easing and the lowest real interest rates in history.” So past cycles might not be a perfect guide to what to expect. Nonetheless, there are echoes in today’s markets of one relatively recent recovery: the sharp rally in 2003 that followed the dotcom bust. This was “classic, early-cycle stuff”, with strong returns for riskier assets. 

Coming into 2004, valuations were high and pricing in plenty of optimism, just like today. Over the next year, the economy remained healthy, growth stayed strong, unemployment fell and inflation rose. Yet US stocks went through a period of consolidation as earnings caught up with valuations. There was no clear trend in which sectors did better globally, but it was notable that non-US markets outperformed the US, despite a modestly stronger dollar.

The same pattern could well play out this time, suggests Sheets. So it may be noteworthy that European stocks have begun to outstrip the US in recent weeks, and cyclical markets such as the UK, Germany and Spain look comparatively attractive, Ray Farris of Credit Suisse tells CNBC. Europe could see earnings grow as fast as the US in 2021, yet valuations are at “multi-decade lows” relative to the S&P 500. “You are getting Europe on sale as it comes out of the pandemic, as it reopens and as growth accelerates.”

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