Macro Update

Despite the pandemic, we have seen a strong economic rebound and stronger than anticipated corporate earnings. What is top of mind for investors now is what comes next.  “Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.” We are yet to observe euphoria in investor sentiments but that will come and we need to be vigilant.

Sanity Check – What has driven the market so far this year?

Given the wide array of economic malaise experienced as a result of the pandemic, it is counter-intuitive to many observers that stock markets should perform so strongly this year.  Markets are generally not disassociated with the real economies over the long run and one of the main drivers of market performance is companies’ reported earnings.

Strong upward revision in earnings has been one of the main supports for the stock markets. 2021 earnings per share has been upgraded by 20% so far this year in the US and by 18% in Eurozone.

Change in consensus 2021 EPS

Source:IBES

In the absence of another complete lockdown as seen in 2020, we expect earnings to continue to surprise on the upside and provide key support to the markets for remainder of the year.

Earnings are only half of the equation. In the context of positive earnings surprise, how expensive or attractive are the stock markets? Strong earnings have allowed for some natural derating or contraction in the forward Price to Earnings multiples. For instance, U.S. and Canadian stock markets are still one standard deviation higher than their historical averages.

S&P500 P/E Multiple

Source: RBC Capital Markets

TSX Composite P/E Multiples

Source: RBC Capital Markets

Central Banks tapering and the trajectory of interest rates

Benchmark interest rates set by central banks strongly influence the cost of capital. By setting the cost of capital low, central banks have implicitly encouraged the purchase of financial assets while making holding cash less attractive. Accounting for the rate of inflation, real interest rates are now negative in most of the developed economies, this means depositors are paying a price for having their cash in savings account.

Many argue the high P/E multiples are justified given low interest rates and cost of capital, and it might stand to reason P/E multiples will contract if interest rates are to move higher in the future. This is not necessarily true, in fact, the historical correlation between U.S. forward P/E and bond yields have been more positive than negative. A confluence of other factors such as corporate earnings, GDP growth, fiscal policies etc. also have significant influences on market valuations.

Overall, we expect strong earnings to be the key driver and provide support to the markets for remainder of the year in the absence of another major lockdown and roll back of economic activities. Growth acceleration has slowed since the reopening of global economies but the projections for 2022 are still positive in earnings as well as GDP growth which should translate into lower but positive market performance for 2022.

 

Rita Li works with individuals and business owners and healthcare professionals to provide tailored investment advice, risk management and financial planning. Her team comprises of professionals with in-depth taxation, insurance and legal expertise, together, they deliver a high standard of service to clients. Rita is a Chartered Financial Analyst CFA® and holds her MBA from Richard Ivey School of Business.