By Rupert Thompson, Chief Investment Officer at Kingswood
Equities continued their upward trend last week, with global markets gaining 1.2%. They are now some 0.8% above the highs seen prior to the mini-correction in mid-July. The continued gains have been warranted by the second quarter reporting season. This is now drawing to a close and has seen earnings beat expectations substantially.
The beat looks likely to be biggest in the US. Earnings for the S&P 500 are set to be up over 90% on the lows seen a year ago, versus expectations at the start of reporting for a 65% increase. However, earnings have also surprised positively elsewhere, albeit not quite as spectacularly, with gains of around 75% likely in both Europe and Japan.
In the US, Friday’s employment report for July has also eased worries about the threat to the recovery posed by the Delta variant. Infection rates have risen significantly recently, even if they are still running a bit lower than in the UK. Payroll growth was stronger than expected and has picked up significantly in the last two months, suggesting the bottlenecks in the labour market are now easing.
In the UK, the recent unexpected slowdown in infections and an easing of the pingdemic have been undoubted good news, even if the weather has done its best to dampen spirits. But it was the Bank of England which was the main focus for the markets.
The Bank turned rather more hawkish at its latest meeting. It now believes a modest tightening in policy is likely to be necessary over the next couple of years to keep inflation under control. The change in tune was triggered by a large upward revision to its inflation forecast. Inflation is now expected to peak at 4% later this year rather than 2.5% as before.
The rebound in energy prices and an end to the VAT cut for the hospitality sector are behind a good part of the rise. But even after excluding these, inflation is still forecast to increase to 3%, before falling back to the 2% target in early 2023. Just as in the US, the bottlenecks being encountered as the economy re-opens are proving unexpectedly severe and are putting more upward pressure on wages than anticipated.
The first UK rate hike could now feasibly occur late next year although, on balance, lift-off looks more likely in the first half of 2023. Of course, rate increases only comprise part of the tightening process, with the rundown of quantitative easing being the other key component.
The Bank also clarified its plans on this front. The bond purchase programme will finish as planned at the end of the year. Then, once rates have been raised to 0.5% from their current 0.1%, it will start a passive rundown of the bonds on its balance sheet. A more aggressive and active reduction is not anticipated until rates reach 1.0%.
These plans leave tightening look set to start rather sooner in the UK than the US. The BOE should have stopped buying bonds altogether by the time the Fed starts to slow or ‘taper’ its purchases at the start of next year. As for the first rate hike, most likely it will occur at a similar time in early 2023 although the risk now is the UK moves a bit earlier.
With central banks set to start gradually removing the punchbowl from early next year, there will be less liquidity around to push equity markets higher. Continued high cash levels of investors may compensate to some extent. But, along with a marked slowdown in earnings growth from the current highs, this suggests further gains in equities will be much more gradual.
Even so, with return prospects for fixed income looking meagre, equities should comfortably outperform bonds. This in turn justifies us continuing with our current moderate pro-equity stance.