Stockmarkets are due a breather

Stockmarkets have started 2021 well, but it may not seem like that for most UK investors. A strong pound has reduced year-to-date returns from the US, Europe and global indices from double digits in local currencies to 8.1%, 8.8% and 6.8% in sterling respectively. The UK, up by 10.8%, has done better but investment trusts have lagged, with the sector’s index up by just 4.2%. This is largely due to the switch from growth to value. Most trusts favour the former over the latter. 

After the extraordinary returns from growth investing last year, investors can hardly complain about a modest setback while value trusts were due some catch-up. From here, the bull and bear factors are evenly matched. The pessimists point to rising bond yields as evidence that the multi-decade decline in bond yields and inflation is over, but the yield on the ten-year US Treasury has only risen from ultra-low levels below 1% to around 1.7%. Elsewhere, the absurdity of negative bond yields is disappearing, but this does not mean investors fear inflation.

The bears argue that bond markets are rigged by massive central-bank buying; governments, supposedly, are spending like drunken sailors and central banks are financing them by effectively printing money. In the short term, economies are booming, but before long, they claim, too much money will be chasing too few goods and inflation will spiral upwards, as it did in the 1970s.

Is the consensus wrong?

Anatole Kaletsky of Gavekal describes this as “an inflation panic”. While not disputing higher inflation in the short term, or even a long-term uptrend, he argues that central bankers are focused on “labour-market data that still points to vast excess capacity” and “an expected surge in productivity”, while resilient markets “seem to attach a negligible probability to any kind of inflationary disaster despite continual warnings from market commentators”. He reported a few days after making these mild and cautious observations that they had “generated a strong response from clients and colleagues, who almost unanimously disagreed with my view”. The inflation hawks are not the contrarians but the consensus.

Ed Yardeni of Yardeni Research argues that the factors that led to an inflation spiral in the 1970s are no longer there. Severing the dollar’s link to gold led to the dollar “plunging by 53% relative to the deutschmark during the decade”. Commodity prices soared and “cost-of-living adjustment clauses in labour union contracts caused these price shocks to be passed through into wages. Productivity growth dropped to zero so the annual growth in unit labour costs soared from about zero in the 1960s to over 10% in the late 1970s”. As for now, “severe labour shortages suggest that wage growth is likely to head higher but we expect that productivity growth will keep pace so rising wages will be justified by rising productivity”.

The extravagance of Biden’s spending plans is causing widespread concern, but these are likely to be tempered in their passage through Congress, where the Democrats have a wafer-thin majority and some of their number have misgivings. “At least 22 states are responding to severe labour shortages by no longer paying $300 per week in enhanced federal unemployment benefits,” which “might encourage more of the unemployed to get back to work.” The eventual cost of Biden’s plans could end up far below the headline numbers. That is also apparent in the UK, where government borrowing is significantly undershooting the forecasts of the Office for Budget Responsibility. The extent of government extravagance in the UK as well as the US has been exaggerated, while EU constraints have held back European governments.

The impact of Covid-19 has proved smaller than expected, with the US economy forecast to return to pre-pandemic levels around the middle of 2021, the UK in early 2022 and the EU, on average, soon after. As a result, corporate earnings have beaten forecasts by wide margins: in the US, first-quarter revenues of the S&P500 were a record 3.8% ahead of forecasts and earnings 23.4% ahead. In the medium term, higher corporate taxes will restrain growth.

With inflation and bond yields set to tick higher only slowly, strong economic growth in 2021 and 2022 looking assured and corporate earnings rising at least at a brisk clip, what can go wrong for equity markets? The answer is simple: valuations are high. The S&P 500 is on 21 times Yardeni’s estimate of earnings for the next twelve months, the highest since 2001. It is hard to see this multiple rising and easy to imagine it dipping to 18 times, implying a 15% drop in markets. 

Earnings growth will steadily bring the multiple down. Yardeni notes that the forward multiple of the “Magnificent Five” (Apple, Microsoft, Amazon, Google and Facebook) has already fallen from 47 in February to 33.5. The US looks set to mark time for at least six months and though other markets look better value, the global tone is often set by America and significant outperformance is unlikely. The scope for value to outperform growth also looks limited. This doesn’t justify selling equities now, but buyers may want to hold off for a better opportunity, or else recognise the need for patience.