Head of Equity Strategy
Summary: Q2 earnings were down 22% q/q which was worse than expected but equities have continued to rally through the earnings season to new all-time highs. It is clear that investors are pricing in a 'new world' as the dividend futures curve is not pricing in high growth rates in the future. Investors are most likely orienting their portfolios towards a future with lower yields for longer and low growth which will cause valuations to rise further on technology companies that have higher than average growth in free cash flow and demonstrate predictability in those cash flows.
The Q2 earnings season is 90% done in the case of S&P 500 and Europe is only missing around 20% of its earnings releases. At this point it is safe to conclude where we landed in the last quarter. Consensus expected a 15% q/q EPS decline in S&P 500, but reality turned out to be much worse with EPS down 22% q/q. Estimates of coming quarters have been revised down lately from new peak in EPS by Q1 2019 to now around Q3 2021. Consensus estimates for FY21 EPS has stabilised and have moved a bit higher over the past three months from $161 to a $165 which equites to a forward P/E ratio of 20.5x for the S&P 500 which compared to the offered credit yields still makes equities attractive.
Dividends futures pricing expected dividends in S&P 500 in FY21 have gone nowhere since late May and still sit 22% lower than prior to the reality of the COVID-19 pandemic. The most obvious explanation since earnings expectations are looking for a fast rebound is that companies with lower than payout ratio for years to come to repay the debt accumulation through the COVID-19 pandemic. The dividend futures curve is a bit more difficult to explain since it reflects a 2% growth in dividends after FY21 and never gets above the previous peak. One explanation for this phenomenon could be that companies recognize the lower yields everywhere and thus are under no pressure to compete with high dividend yields. Instead they can do what equities are supposed to do; namely invest in growth and deliver future growth and capital accumulation through investments in upgrading machines and processes to enhance productivity.
If investors are looking through a terrible Q2 earnings season and take the dividend futures curve at face value, what then are investors pricing? In our view, investors are pricing a new future which means stronger focus on fiscal impulse via monetization (“the magic money tree”), technology eating more of the world’s value, lower growth rates and lower yields for longer. As we have talked about in recent research notes this creates an environment where large stable technology companies with high ROIC and predictable growth and free cash flow generation will be bid up in value to be bond proxies. This will acceleration equity market concentration to levels not seen since the 1970s with IBM in the lead. All roads from here leads to inflation and one of the only asset classes that can protect investors is equities which have historically absorbed inflation well up to around 3.5% in inflation over a sustained period. As we have argued lately, the policy actions and the pricing of bonds leave investors with little choice than to race after equities, gold, real estate and other long duration assets.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
