Those invested in the broader equity markets should be happy with this year’s results. Despite rising interest rates, new waves of the Coronavirus and China’s backlash against capitalism, risk markets have soared in 2021.
The MSCI World Stock index has advanced by 19.90% through the end of October. After a modest slump in Q3, markets have resumed making new all-times highs on the back of strong corporate earnings and an economic rebound. Leading companies have managed to grow both their top and bottom lines throughout this year’s choppy recovery, seemingly against all odds.
While equity markets have fared well lately, investors should be watching a few critical markers which could have both short and longer-term impacts on investment portfolios. Indeed, a key to navigating these markets may lie in discerning the difference between short-term noise and longer-term secular trends. Important markers along the winding road of the pandemic recovery include central bank monetary policies, inflationary pressures, supply chain issues and fiscal stimulus plans.
In terms of U.S. monetary policy, most economists expect longer term interest rates to resume their gradual upward trajectory through the balance of this year and into 2022. Federal Reserve Chairman, Jerome Powell continues to confirm the central bank’s resolve to begin tapering, or winding down the systematic purchasing of government notes and mortgage-backed securities in the open market.
After a strong first half of 2021, macroeconomic data has recently been more mixed, but so far that has not altered the Fed’s strategy. For example, recent U.S. employment reports have fallen short of expectations and Q2 gross domestic product growth has declined to a post-recovery low; and yet that did not materially alter the Fed’s narrative. Economists still expect the Fed to begin tapering bond purchases this month with the intention of winding down the current quantitative easing (QE) programme by next summer. Actual interest rate rises, however, will take longer.
According to the September Federal Open Market Committee (FOMC) minutes, Fed policymakers believe the Delta wave of COVID-19 cases around the world “were exacerbating or prolonging” the supply chain bottlenecks that have forced many auto plants to shut down and pushed up prices for consumer electronics, home furnishings, clothing, and imported goods. Thus, inflation has become a larger concern in the near term.
Successful resolution of today’s major supply chain problems therefore represents another key market marker. These disruptions have led to both higher prices and significantly longer delivery times for many products. ISI/Evercore’s recent survey data suggest that most managements have pushed out their expectations for when the current supply strains will be alleviated, from early-to-mid 2022 to the second half of next year.
The current situation seems to be separating the proverbial wheat from the chaff. Some well managed corporations have demonstrated adeptness in managing through the disruption and those market leaders with loyal customers and value-added products have been able to pass on higher costs to consumers. Weaker players are stuck absorbing costs and, in some cases, have seen lower volumes.
Paper products company, Kimberly Clark for example, reported a disappointing quarter last month slammed by supply chain issues. Chief Executive Officer Mike Hsu stated “Our earnings were negatively impacted by significant inflation and supply chain disruptions that increased our costs beyond what we anticipated.” Kimberly Clark stock fell 2.23% last month, underperforming the MSCI World Stock index by about seven percent.
On the other hand, Raytheon CFO Neil Mitchill, called out big gains in commercial aerospace aftermarket businesses of Collins Aerospace and Pratt & Whitney. According to a Bloomberg report. “Raytheon’s dealing with supply-chain turmoil like everyone else, namely in the form of longer lead-times for components and some labor shortages. But the company has deployed countermeasures such as sourcing from multiple suppliers where possible and expanding “buffer stock” purchases to deal with delayed shipments from suppliers.”
While supply chain issues linger, investors are also hoping for a budget resolution in Washington. Longer term market followers may recognise America’s apparent political dysfunction as just part of the typical sausage-making process required to grind out large pieces of legislation.
Democratic policymakers have promised innumerable “free” goodies to their constituents and now they are expected to deliver. As I write this, representatives are working on an approximate $1.75 trillion framework aimed at education, healthcare and climate change. Democrats have reduced their ask from an initial $3.5 trillion price tag with some programmes, such as free community college and a full Medicare benefits expansion, having been taken off the tale.
Expect a finalised deal this year with the requisite compromises on both sides of the aisle. Markets will likely applaud any final outcome that falls between the goal posts. A budget deal and stimulus plan will remove one key uncertainty and may also boost economic growth in some sectors, albeit at the cost of further sovereign indebtedness.
Expect ongoing market volatility and sector rotation in the months ahead as investors continue to weigh the prospects of growing corporate earnings against the headwind of waning monetary stimulus, even as the pandemic recedes and supply chains begin to clear.
In terms of valuations, analysts are expecting a 27% increase in earnings per share over last year. In recent weeks, earnings expectations have outpaced stock prices, leading to more attractive relative valuations. The price-earnings ratio on the MSCI World Stock index has declined from a high of over 25x forward earnings last summer to just around 20x. This lower valuation leaves room for stock market upside if corporate earnings continue to deliver.
Bryan Dooley, CFA is Head of Portfolio Management at LOM Asset Management Ltd in Bermuda.
Please contact LOM at +1 345 233-0100 or visit www.lom.com for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.
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