A year on from the arrival of a global pandemic, and we finally have reason to feel optimistic again. The government has laid down a roadmap to normal life, and key data indicators are already pointing to a strong economic recovery in the next two to three years. Here we discuss why investors can legitimately feel confident about the future.
Productivity improvements
- The recession has forced businesses to become more efficient by reducing overheads and adopting new technology. This will feed into productivity and profitability when the economy starts to recover, resulting in businesses being able to deliver on – and perhaps even exceed – their carefully laid plans.
Supportive monetary and fiscal policy
- Governments are being empowered to spend by central banks, with the US leading the way in supportive monetary and fiscal policy. President Biden has laid down significant spending plans, and the Federal Reserve is happy to print money in order to buy government bonds necessary to support that. In the short to medium term, this approach will help to fuel economic growth.
Economic indicators suggest global economic expansion
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Forward-looking economic indicators such as the Purchasing Managers’ Index (PMI) are improving, with the PMI’s manufacturing index at its highest level for over two years. In April 2020, the average index score across the G20 was 36. In January 2021, it was 54, signifying an outlook of growth and expansion.
Vaccines will help to reopen the economy
- The UK is leading the world with its successful rollout of the Covid-19 vaccine. This will ultimately enable the reopening of a meaningful economy, which will reduce unemployment levels and unleash pent up consumer spending.
Cheap finance drives investment
Surge in capital expenditure
- Moving from a carbon-based economy to one underpinned by renewable energy is a hugely capital-intensive shift. Governments now have an opportunity to direct capital injections towards these sorts of projects, which will become a revenue opportunity for some companies and a creator of jobs.
“As far as monetary policy is concerned, governments and central banks intend to keep the pedal to the metal for as long as possible. The demonstrable success of vaccination programmes, a significant and sustained investment surge to build out renewable energy infrastructure, and productivity improvements from an accelerated adoption of technology are all reasons to believe that economic growth will remain strong in the next few years.” Philip Smeaton, Chief Investment Officer
Investment View: Are current equity valuations justified?
It’s a year since the stock market crashed so spectacularly, and the world woke up to the reality of life amid a global pandemic. Since then, despite the absurdity and uncertainty of it all, equity valuations have climbed back to new highs. But are these valuations justified, or should we be preparing for another market shock?
As investors, we are continually focused on the value of stocks, and whether that value is fair or not. When the market crashed last year, valuations plummeted, which compensated investors (perhaps even excessively so) for the risk they were taking amid the uncertainty. Now those valuations have hit new highs, but there is still a large amount of ambiguity, which is why we must question if prices are fair, or whether it’s time to recognise that valuations are excessively high and therefore pare back our exposure to equities.
Using ‘earnings per share’ as a valuation tool
One way of determining a company’s value is to look at its earnings per share, which is its net profit divided by the number of shares issued. This is a good measure of profitability, and therefore can be used to derive an estimate for the fair value of a company.
Chart A shows the average earnings per share across companies within the MSCI World Index since 1995, with a smooth long-term trend line overlaid across them. As you can see, earnings dipped considerably below the long-term trend line last year, in the same way they did after the dot-com bubble burst in 2001, and in the aftermath of the financial crisis of 2008 and the energy crisis of 2015. But what the graph also shows is that the earnings per share tends to rally after a recession. This happens for several reasons including government and central bank support, cheap access to credit and spare capacity in economies being used once again.
Chart A: Earnings per share (USD), MSCI World Index. Source: Bloomberg
As economic conditions start to improve, the consensus view (which is marked with the red crosses) predicts a confident recovery in corporate earnings over the next two to three years. While the consensus view tends to be fairly bullish, chart B shows that 85% of companies in the S&P 500 beat predicted quarterly earnings in the third quarter of last year – the highest level for three years.
Chart B: S&P 500 Index % of quarterly earnings beating consensus estimate. Source: Bloomberg
Conclusion
As a result, we are optimistic that despite high current valuations, future returns are indeed achievable. Along with careful stock-picking, we think it’s important to continue participating in stock market gains, while also ensuring we have some capital set aside to take advantage of any opportunities that arise. We believe that the current environment is accommodative for equity prices and whilst there will almost certainly be periods of volatility for investors to endure over coming months, there are plenty of reasons to be optimistic about the medium-term outlook.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.