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Be wary of Goldilocks

By Clive Emery, Multi Asset Fund Manager at Invesco

Key Takeaways:

  1. Headwinds for corporate margins are growing
  2. Supply chain costs and post-covid reopening costs could have negative implications
  3. Rising taxes and wages may also impact bottom lines

There’s nothing quite as disconcerting as being told everything is set fair. Though growth and earnings remain positive, real yields plague fixed income markets. This is perpetuating the ‘TINA’ (There Is No Alternative) phenomenon for equities, even though they look expensive.

But high valuations and a positive consensual outlook are wary bedfellows, causing us to reflect on what could cause some temperance. Even though valuation corrections don’t always require market pullbacks, they do impact returns and so greater caution is necessary.

There are two main short-term concerns that could unsettle the outlook. Both margins and the 2020/2021 retracement of fiscal and monetary splurges suggest that valuation pullback in equities is a real possibility. The outlook is positive medium to long-term, but in the short-term we wouldn’t be surprised to see some volatility.

The summer unwind

The summer saw markets steadily pricing-in concerns about slower economic growth and weaker inflation, leading to an unwind of the reflation trade. This has brought lower bond yields and in the equity market, outperformance of quality over value. The reversal has been so significant that the relative performance of value stocks is near to 2-year lows, while quality and growth equity indices near 2-year highs. On a sector-neutral basis, the valuation dispersion between growth and value is now comparable to the extreme levels seen in 2000.

We’re not concerned about revenue expectations, given strong growth forecasts and higher savings ratios. The current earnings expectation of 6.9% for MSCI Europe is the lowest in 30 years and expectations are even more modest in the UK where implied 12-24m earnings growth is sub-3%. However, one reason for this relatively anaemic forecast growth rate is the large increase in current year forecasts. Earnings have continued to be revised higher in all regions; Japan leading the way with close to all-time high earnings revisions. This has supported a 13.5% month-to-date rally in the Japanese equity market at the time of writing.

The core reason for this is that many corporates have been able to cut office, travel and entertainment costs among others, as well as staff costs. Think reception, security and catering – many in these areas have been furloughed or laid off. This reduction in fixed costs, led to an historic increase in global margins of 280bps. Notable, at a time that revenues didn’t fall as much as would be typically expected and given the historic fiscal programs to alleviate the impact of economic closure.

Is the market mis-reading margins?

We are concerned about margins though. What impact will re-opening have here? Interestingly, there’s a lot of focus on the potential negative impact of supply chain costs but little in the way of discussion around the cost of Covid re-opening. We’re worried about the implications of both and about the implications of potential corporate tax increases which makes the current market consensus that margins will be flat year on year seem a little incongruous.

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