Quality not Quantity

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Global equities continued their recovery last week, ending up 2.1% in local currency terms. Markets are now down only 1.2% from their early September high. So, why the swift rebound from the long-awaited 5% correction at a time when the macro environment has turned more hostile? Most likely, it is because two key factors behind the sharp rebound in equities over the last year still remain supportive.

First, the buy-on-dip mentality which has curtailed any equity correction this year has been fuelled by TINA – the belief that There Is No Alternative – to equities. The outlook may no longer be half as good as it was but still looks better than for bonds, the main alternative for most investors.

Prospective equity returns over the coming year are likely to be no more than high single digits at best. However, this is still significantly better than the returns on offer from fixed income. 10-year UK gilt yields may have doubled in the last couple of months but are still only 1.2%. If as seems likely, yields continue to trend higher, gilts are set to deliver negative returns.

As for corporate bonds, the outlook is only a little better with their yield pick-up over government bonds at historical lows. Investment grade corporates on average yield around 2.5% in the UK and US and face the likelihood of capital losses. By contrast, UK and US equities currently yield over 3.2% and 1.3% respectively and have the prospect of capital gains.

The second factor behind the equity rebound is corporate earnings. The third quarter reporting season has got off to a strong start with the big US banks beating expectations significantly. They benefited from the M&A boom boosting investment banking revenues and smaller than expected pandemic-related losses on their loans.

The expectation now is that US financials and large cap stocks overall will both see earnings up a touch over 30% on a year earlier. Earnings growth is slowing as a result of the weaker economic backdrop and upward pressure on costs but should still drive further gains in equities in the medium term.

Near term, however, the macro environment has clearly turned distinctly more murky. There is more than a whiff of stagflation which was confirmed by last week’s raft of data. US inflation was a tad worse than expected in September with the headline rate running at a high 5.4% and the core rate (excluding food and energy) at 4.0%. At the same time, wage growth picked up further both in the US and UK with no sign yet of any easing of the labour shortages.

As for growth, today’s numbers from China showed GDP posting only a modest 0.2% gain in the third quarter. This left GDP up 4.9% on a year earlier, a far cry from the double-digit growth rates seen early in the year and also low by China’s pre-pandemic standards. Growth has been hit by renewed lockdowns over the summer and more recently power shortages. In addition, there is now the demise of Evergrande which is casting a shadow over the whole property sector.

The Chinese authorities are now putting much more emphasis on ‘common prosperity’ and the quality, rather than quantity, of growth. Even so, we do expect policy to be relaxed somewhat in order to prevent a further slowdown into 2022, which is an important political year for the Communist Party.

Closer to home, Andrew Bailey, the Governor of the Bank of England, stated over the weekend that the MPC will have to act to curb inflationary pressures. His comments cemented expectations that UK rates will be raised before year-end and investors are now pricing in rates increasing to 1.2% by the end of next year.

Despite the swift rebound in the last couple of weeks, we expect equities to continue to face a choppy environment over the next few months. Slowing growth, mounting inflation pressure and policy tightening are all likely to generate further volatility. Only as it becomes rather clearer that we are not heading into a new era of stagflation, will any further gains in equities have a firm footing.

Rupert Thompson

Chief Investment Officer