Global stock markets have stagnated in recent weeks despite a deluge of strong earnings and economic data, but analysts think the rally will regain momentum.
The current round of corporate earnings is proving to be one of the most successful in history with more than a third of blue chip companies having reported so far, Barclays analysts noted on Thursday. Earnings per share growth has vastly exceeded expectations in the U.S. and Europe and the proportion of earnings beats is close to a historical high.
However, analysts have suggested that high expectations have largely been priced in, meaning the share price reaction thus far has skewed slightly to the downside.
A spike in inflation has also been cited as underlying some investor reticence toward risk assets, with concerns persisting that central banks will begin scaling back their unprecedented monetary stimulus.
Inflation spike not the end of the rally
The latest inflation readings out of the U.S. and Europe have risen sharply, and UBS strategists anticipate that this will continue over the coming months with signs of price pressures enduring.
However, in a note to investors Thursday, they attributed this to base effects and short-term supply constraints, rather than structural issues.
UBS Global Wealth Management Chief Investment Officer Mark Haefele said this indicated that the spike in inflation will likely be transitory and should be seen as a potential source of volatility, rather than a long-term threat to the overall equity market rally.
“With economies still running below potential output, we don’t currently forecast a sustained rise in inflation that would compel central banks to tighten monetary conditions,” Haefele said.
U.S. Federal Reserve Chairman Jerome Powell alluded to this following the central bank’s monetary policy meeting on Wednesday. The Fed expects the current spurt of inflation to be transitory and still sees considerable slack in the labor market, meaning policy is unlikely to be tightened in the immediate future.
Haefele suggested that the Fed actually wants inflation to overshoot its 2% target in order to offset a long-standing undershoot in recent years.
He also highlighted that profit margins do not seem to be at risk due to the temporary rise in costs.
“While input prices have risen for many companies, we do not expect this to be a significant headwind for earnings,” Haefele said.
“In an environment of strong consumer demand, we expect revenue growth to help offset the drag from input costs,”
While a transient inflation spike may cause some investor jitters that leads to increased volatility, UBS anticipates that equity markets can continue to climb, favoring cyclical stocks — those whose performance tends to align with macroeconomic conditions — as the global recovery broadens out.
Vulnerable to shocks
Barclays highlighted that mutual fund buying has slowed from its record pace in the first quarter, while trading volumes and retail participation in stock markets have tailed off significantly, with cash being spent in the economy as it opens up.
The British lender has previously flagged that unfavorable technicals and seasonal trading trends could mean the market is at risk of a pullback, should a substantial negative catalyst arise.
Although the market is more vulnerable to bad news, Barclays Head of European Equity Strategy Emmannuel Cau believes investors will continue to buy dips given the strong earnings, abundant liquidity and high level of holdings in bonds and cash at present.
The S&P 500 opened at record highs on Thursday on the back of blowout earnings, having struggled for direction over the past two weeks following a rally of more than 12 months since the recent lows of the March 2020 coronavirus crash.
However, he argued that with the reflation trade stalling, value stocks — companies whose shares are cheap relative to their fundamentals — offer better risk-reward than cyclicals.
“While Cyclicals are supported by strong earnings, we think valuations and positioning are now less favorable, which calls for a more balanced allocation vs. the less exciting but cheaper Defensives,” Cau said in a note to investors Wednesday.
“We continue to see Value offering an attractive hedge against higher inflation and rising yields, while it could also catch a bid from momentum strategies.”
David Marchant, CIO of Canada Life Asset Management, told CNBC on Thursday that the market may be underestimating the scale of the economic recovery and its potential impact on corporate earnings, given that companies have cut costs during the pandemic but will now begin to see sales start to rise. However, he echoed Barclays’ call for investors to hedge against downside risks.
“Whilst I still think given where we are, given the ongoing support for markets from monetary policy, equities will probably stay up and may continue to drift higher, but I just think you need to exercise a degree of caution, be a little more selective about where you are putting your money,” he said.