By Matthias Busuttil
Financial markets have rebounded remarkably fast from the sharp drawdown of March 2020 when COVID-19 impacted the global economy. Taking the MSCI World Index as a measure of equity market performance across 23 developed markets, it took less than 6 months to recover the 34% decline during the bear market. By comparison, it took over three years to recover the 55% market losses during the great financial crisis (“GFC”) of 2008 and 2009. Looking at less prominent events of between 10% to 30% declines in equity markets, it has on average taken just under 12 months to recover bear market losses.
It has been well documented that both the exogenous nature of the economic shock and the unprecedented policy support that followed limited the risk of extensive systemic or structural damage, while economic players and productive capacity were, by and large, safeguarded. As economies were able to cushion the impact of the pandemic, confidence and activity bounced back sharply as COVID risks started to subside and the vaccine rollout started to show promising signs.
This explains the strong performance of risky assets during the second half of 2020 and early 2021 given the growing evidence of a reflationary cycle with the MSCI World Index returning circa 16% in 2020 and circa 19% this year up to end-October. However, more recently the focus has shifted toward stagflation concerns characterising the risk of a period of slow economic growth and high inflation. These concerns are based on signs that the growth momentum is decelerating, fiscal boosts are beginning to fade and major central banks are becoming increasingly jumpy to terminate emergency monetary injection programmes and hike rates with the primary scope of reeling inflation expectations back down towards their preferred target area.
Despite these concerns, consensus forecasts are still pointing to an above-average real GDP expansion of 3.9% in 2022 and 2.3% in 2023 in developed economies. Inflation is expected to remain high in the first half of 2022 given the rate of price increases in durable goods, food and energy. The prolonged supply chain disruptions and short-term imbalance in demand and supply dynamics during the economic reopening are expected to start to normalise in the course of 2022 resulting in a moderation in global inflation rates. The inflationary boost from durable goods is expected to translate into a net disinflationary drag as bottlenecks ease. Energy prices are not expected to rally much higher as production increases and inventories are replenished.
After a strong rebound in corporate earnings growth in 2021, which is expected to be 49% following a contraction of 22% in 2020, consensus estimates are pointing towards reasonably high earnings growth rates of 8% in 2022 and 5% in 2023. The supportive macro backdrop and the fairly strong earnings growth expectations should sustain the current market rally, albeit at a slower pace compared to 2021.
Elevated inflation expectations and the continued decline in real yields has so far been supportive for equities. Moreover, current conditions brought back the prospects of value stocks outperforming given the expectations of higher nominal rates, after years of underperformance since the GFC, particularly in sectors that generally see higher revenues in periods of economic expansion and business models that can pass on higher costs and protect profit margins.
Having said that, current valuations are also high with forward-based metrics of major equity indices ranking in the top 10-percentile in historical terms. While, more broadly, all the main asset classes are trading at high valuations, equities still look attractive on a relative basis particularly given the higher inflation protection in stocks and the record low levels of nominal yields in fixed-income instruments. This is seen in the relatively high implied equity risk premia reflecting the additional internal rate of return required by investors at current prices.
In the absence of an unexpected economic downturn or a rise in real yields, equities are positioned to continue to deliver strong returns in 2022 and outperform fixed income markets. Given the buoyant inflation and growth expectations, a gradual and measured monetary policy normalisation process towards higher rates, on the back of stronger growth, should positively lead to a more normal correlation between equity and fixed income markets. On the other hand, an abrupt surge in bond yields due to an uncontrolled drift higher in inflation expectations or disruptive tightening by central banks could trigger a correction in equities. Particularly, the change in yields required to derail the equity rally could prove to be much smaller this time given the higher valuation levels and the still fragile economic conditions.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.