Last month we thought that global monetary policy would dominate the headlines in the financial markets. The September meeting of the US Federal Reserve (Fed) did not bring any new information, and the general assumption remains that the Fed will announce its asset-reduction plan during its November 2021 meeting. Other central banks, such as the Bank of England, indicated that they would hike short-term rates earlier than market expectations. In our opinion, changes in monetary policy are the most significant known risk in the financial markets today. At the beginning of October, we expect corporate earnings to be the main thing while the inflation debate becomes less loud.
Braking at high speeds
In the most recent quarter, U.S. stocks posted a staggering 91% earnings growth over Q2 2020. Part of this growth can be attributed to a low starting point, but the exceptional monetary and fiscal stimulus likely contributed. For this quarter, the market expects a growth rate of around 28% (Q3 2021 vs. Q3 2020), and if that figure is hit it would be the third highest on record.1 Thus, earnings growth in US equity markets will start to slow, but in a historical comparison are still well above the average. About 70% of the S&P 500 will have released third quarter 2021 results by the end of October.
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Figure 1. Earnings growth US stocks
Source: Innealta Capital, Bloomberg and Factset. Period from December 31, 2019 to September 30, 2021. * refers to profit estimates based on Factset.
US stock markets are not cheap by valuations. The price-earnings ratio (“PE”) of the twelve-month forward S&P 500 is 20.9x, well above its 20-year average of 15.6. High ratings do not mean an immediate downfall, but in our opinion they create significant headwinds. For example, suppose we construct a simple model to approximate the annualized total return over the next five years, taking into account the current S&P 500 forward PE ratio and ten-year interest rates. In this case the model suggests an annualized return of 9 %2. An annualized return of 9% looks attractive, but appears rather low compared to the annualized return of the last five years (+ 16.90%). Given the high valuations and above-average earnings growth expectations, any failure in corporate earnings for the third quarter of 2021 is likely to result in bigger drops than we were used to this year.
Figure 2. US stock market valuations
Source: Innealta Capital. Bloomberg. Time frame 09/30/2001 to 09/30/2021. “US Stock Market” refers to the S & P500. Valuation refers to the twelve-month forward price / earnings ratio
The inflation debate
The US consumer price index in August showed a year-over-year increase of 5.3%. Excluding food and energy, the CPI rose 4% last year. It is an important reminder that the economy and financial markets are not the same. The Fed, the biggest buyer in the financial markets, has hinted that inflation will ease as supply chain bottlenecks are removed. When the Fed hits its inflation and employment targets, it will begin reducing asset purchases and raising short-term interest rates. The October 13th CPI measurement is unlikely to end this debate, but many financial market participants will be watching this data point.
Figure 3. U.S. Consumer Price Index (CPI) Growth
Source: Innealta Capital. Bloomberg. Period 08/31/2000 to 08/31/2021. Frequency monthly
With less than three months to the end of the year, we believe the macro headlines will have a much bigger impact on the financial market than their micro counterparts. The most important macroeconomic factor in financial markets today is global monetary policy. Monetary policy changes raise the following concerns in financial markets:
- When will it go from accommodative to contractive and by how much?
- Can the financial markets continue to function if monetary policy becomes a headwind rather than a tailwind?
- Overall, how will companies deal with above-average inflation and declining fiscal / monetary incentives?
- Will growth rates stay high enough to overcome the increased valuations?
Although these questions will take months or years to answer, we believe that an active approach should produce better results than a passive one in this market environment.
- Insights into income. 09/24/2021
- Innealta Capital and Bloomberg. Period 09/30/2000 to 09/30/2021. Linear regression model between the trailing five-year total return and the return risk premium five years ago. The return risk premium refers to the difference between the forward earnings-price ratio and the yield on ten-year US Treasuries.
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