Optimism about a protracted economic boom is gaining interest. This week, Jamie Dimon told JPMorgan shareholders that the good times for the US economy “could easily enter 2023”.
Similarly, the IMF’s assessment that the global economy will expand sharply in the next two years, led by the US and developed economies, was also optimistic.
This type of confidence has helped global stocks hit record highs this week. But investors may ask: How much of the good news is already included in stock market valuations?
“The second year of a recovery is getting harder for investors because the stock market is a forward-looking forecast tool,” said Andrew Slimmon, senior portfolio manager, Morgan Stanley Investment Management. “There is a lot of optimism about the reopening of the economy and additional government subsidies, but the market has priced this result heavily.”
One way to gauge how far market sentiment has moved is to simply shy away from the median target of 4,100 points for the end of 2021 for the US stock benchmark expected by Wall Street analysts surveyed by Bloomberg. It’s a similar story as a global investor shifts to companies that are expected to benefit from a vaccine and restoration of incentive-driven economic activity throughout 2021.
The European Stoxx 600 climbed beyond the average analyst year-end target of 435 points for benchmarking. Japan’s Topix remained well above its mid-year target of 1,700, even though it retreated one touch from the March high of 2,000.
Strong performance exposes sentiment to negative developments while raising the bar for future returns as required. Among the challenges that arise, corporate profits must exceed current forecasts to drive more market gains.
Profit growth for the MSCI All World index is forecast to recover 29 percent in 2021, according to Citi analysts. This situation trades the market from top to bottom, up to 19 times the forward-looking earnings forecast over the next 12 months.
Throwing some sand into the bull market gears is the possibility of tax increases for global corporations, and the Biden administration is proposing a new model for collecting multinational corporations and the global minimum corporate tax.
Higher taxes from 2022 are not a good combination for corporate margins, as governments try to offset the cost of outbreak stimulation efforts and increased input costs.
Another emerging area of concern is the possibility that the tightening of credit standards in China will overthrow European companies and commodity producers. That is why MSIM’s portfolios are more defensive in Europe while accommodating circular companies that could benefit from a stronger economy in the US, Slimmon says.
Having low-quality stocks that will profit from a hot economy has been the winning stock strategy in recent months, and it’s a trend that shows signs of fatigue. There are advocates of the trend to have industrial, financial and technology companies with strong balance sheets.
“High-quality stocks have a tendency to perform better after refreshing peaks,” said Jill Carey Hall, equity strategist at Bank of America. According to the bank, high-quality stocks “never saw a 10-year negative return in our data history (until 1986) even if dividends were excluded”.
In the longer term, an important issue for the investment outlook is the legacy of current incentive efforts. Dimon highlighted an important point in his long letter to shareholders: “The lasting impact of this boom will only be fully known when we see the quality, effectiveness and sustainability of infrastructure and other state investments.”
Here, the current level of US 10-year Treasury interest rates shows that faith in this favorable outcome is waning among bond investors. Interest rates have risen sharply this year, albeit from very low levels, and this makes sense when the economy is out of recession and into expansion mode.
But if the stars are indeed aligned for booming economic conditions, the US’s 10-year rating, currently at 1.6 percent, stands out as it failed significantly to surpass the pre-epidemic level of close to 2 percent at this stage of recovery. The beginning of 2020.
This year, although higher interest rates are seen due to increased government spending and inflationary pressure, there is a risk that growth prospects will decline as the incentive continues its course and with all the additional debt piling up in the aftermath of the pandemic.
There is a much more worrying scenario for stock investors who are on the lookout for the return of inflation and much higher bond market interest rates in the aftermath of the pandemic: mediocre long-term growth prospects have remained intact despite major stimulus efforts.