Monthly macro update – September 2021
Snapshot of views
For the past year, we have held a preference for equities over credit, but when may a more balanced allocation become suitable? While we think monetary and fiscal economic support will slow, we expect both to stay accommodative for at least the next 12 months. Even if inflation causes monetary policy to tighten faster than expected (which is not our base case), it will still take time for interest rates to reach punitive levels. Further, equities will have some pricing power to pass through higher costs to consumers, and those higher quality companies with resilient profitability would likely outperform. Therefore, we think it is too early to reduce our equity allocation.
Improved corporate earnings have driven equities higher this year, and we think there are several reasons this can continue. Economic growth expectations are above trend, while household finances remain very healthy. Together with falling unemployment, these factors can continue to act as a tailwind for corporate profitability over the coming year.
Can equities continue to outperform credit?
For the past year, we have held a preference for equities over credit, but as we return to more normal economic conditions, changing this position can be contemplated. We think there are two things to consider here: first, when might policy makers withdraw fiscal and monetary support, and second, which assets perform best in tightening economic conditions. Let’s look at these in turn.
Ultra-loose policy has been the driving force behind markets over the past 18 months, so it is no surprise investors are watching for signs of withdrawal. For interest rates to reach levels that weigh on equity performance would require multiple interest rate hikes, and the ongoing threat of future hikes. While the US Federal Reserve has indicated stimulus tapering could begin soon, we (and the market) don’t expect any interest rate hikes within the next 12 months. Likewise, while the level of fiscal spending by governments has slowed, it remains elevated relative to historic levels. This is a tailwind for economic growth, and with higher short-term inflation eroding the debt to be repaid, governments have a greater propensity to continue to spend. Therefore, our base case is that policy won’t reach levels that are headwinds for equities in the next year.
Source: Bloomberg 9/15/21
What if policy tightens quicker than expected?
However, as discussed in previous Macro updates, there remains a risk that higher inflation causes policymakers to tighten financial conditions sooner than expected. In this higher inflation scenario, is it better to hold equity or credit? In a higher inflation environment, the fixed cash flows of credit assets that aren’t inflation-linked (the majority of the market) lose their relative value, but those equities with pricing power are at least able to pass through some increasing costs to consumers. Thus, higher quality equities with resilient profit margins tend to perform best in this scenario and may well continue to outperform credit, which looks ever more expensive. However, this isn’t just the case in higher inflation periods; in fact, quality -style (e.g. low debt, defensible market position) companies have outperformed over the past decade.
To summarize, we think it is too early to move towards a more balanced equity and credit allocation. Policy should remain supportive at least in the medium term and justify an above average equity exposure, but there will likely be value in positioning towards higher quality companies within equities.
Source: Bloomberg 9/15/21
Can earnings continue to drive equities higher?
At the turn of the year, we expected equities to be driven by higher corporate earnings rather than multiple expansion (the price investors will pay for a unit of profits), and this has very much been the case. While the price to earnings ratio of the S&P 500 has been flat, improving earnings have driven the index up over 20% year to date. We think there are several structural reasons this can continue. First, economic growth should stay above trend for the foreseeable future supported by loose policy and continued societal re-openings. Second, household finances look increasingly healthy. Household debt has fallen sharply while household savings have done the exact opposite, leaving consumers with a larger proportion of disposable income. And third, unemployment continues to recover at pace. Job openings are at record levels which should drive unemployment lower and ultimately improve consumer income as they return to work. Together, we view these structural trends as a tailwind for earnings.
Source: Bloomberg 9/17/21
Investment advisory services are provided by River and Mercantile LLC, an investment advisor registered with the US Securities and Exchange Commission. It is a subsidiary of River and Mercantile Group PLC, a U.K. corporation.
The information and opinions contained in this document do not constitute investment advice and is provided for background purposes only. References to specific securities are provided solely as illustrative examples of the River and Mercantile LLC analytical methods, and are not a recommendation to buy or sell such securities. This information is subject to updating and verification. Portions of this presentation are based on data provided by third parties whom River and Mercantile LLC deems to be reliable; however, River and Mercantile LLC cannot guarantee the accuracy and completeness of the information.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.
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