Please see below for Legal & General’s latest ‘Asset Allocation Team’s Key Beliefs’ article, received by us late yesterday 28/06/2021:
There are still a few weeks until Q2 earnings season, but early indications point to mainly positive news when events kick off properly in July. In this week’s Key Beliefs, we also discuss the ‘meme’ stock phenomenon and whether the 1960s pose a historical parallel for inflation today.
We’re in the middle of pre-announcement season for corporate results. While this is always very anecdotal in nature, company comments have so far had a generally positive tone and, perhaps even more tellingly, there has been an absence of any high-profile negative pre-announcements. Results from early reporters, companies with different quarter ends, have had a similar positive tone.
Another positive indicator is that earnings revision ratios have stayed at exceptionally high levels. There are always fewer forecast changes by analysts in between earnings seasons, but from the data that have come in, there have been far more upward than downward revisions. In May and the first few weeks of June, more than three quarters of revisions in the US were to the upside, a figure only matched in the immediate aftermath of recessions and after the corporate tax cut at the end of 2017.
All of this bodes well for the upcoming earnings season and adds confidence to the view that we’ll see another round of significant upgrades to analyst forecasts in the summer. And of course, significant analyst upgrades either put upward pressure on share prices or downward pressure on valuation multiples. We believe the truth will likely lie somewhere in between and continue the pattern of equities grinding higher at a slower pace than earnings estimates, which gradually deflates the high PE (price to earnings) ratios of the immediate recession aftermath.
Retail is here to stay
Retail investors and ‘meme’ stocks have been centre stage again in equity markets in recent weeks. Three things come to mind on the topic from a macro perspective.
First, the extreme moves continue to be limited to a handful of stocks. There are still no obvious signs of the volatility in affected stocks spilling over into the wider market. If you look closely enough, you can see the gyrations of Gamestop* and AMC* reflected in the relative intraday performance of US small cap indices like the Russell 2000. But the S&P 500 put together a long string of daily moves smaller than 1% in the last period of meme stock volatility.
Second, this most recent rally in retail favourites has been far weaker than what we saw in spring. This applies both to the magnitude of the outperformance of the stocks involved and to retail trading volumes. The share of TRF volumes (seen as a proxy for retail activity) of overall US volumes has stayed in the low-mid 40% range, which is far above pre-2020 levels, but a good bit below the nearly 50% mark regularly reached earlier this year. Overall, it’s still fair to say that the froth that was apparent in several retail-driven niches of the market in spring is much less of a concern today. Indeed, SPAC (‘special purpose acquisition company’) activity and prices have dropped a lot, as have prices in the digital asset sphere, like bitcoin.
Finally, if retail is a growing part of equity flows, then we are still in the early part of this story. The activity has so far been concentrated in Robinhood-type investors, who tend to be younger and less wealthy than the traditional retail investor base. US households own just under a third of US equities, but the top 10% of households own almost all of that, according to Goldman Sachs. Private client flow data from brokers show net purchases of equities this year, but their magnitude still pales into insignificance when compared with the previous decade’s net selling. So far, the increase in retail activity appears to have been driven by the smallest section of retail investors. The private client flow data suggest activity is spreading to traditional retail investors, but from today’s perspective we believe this theme remains much more of an upside than a downside risk.
Sounds of the ‘60s
In the mid-1960s, after years of subdued core inflation, there was a sudden increase which began a period of prices ratcheting higher. Unemployment fell through the first part of the decade, but as soon as it reached 4%, both wages and inflation moved up significantly. This suggested the economy was overheating and unemployment had probably breached the NAIRU a couple of years earlier. Indeed, it took a recession in 1970 to halt wage and price pressures temporarily, before the oil-shock induced big inflation of the 1970s.
The simultaneous increase in wages and inflation is a finding consistent with Ram’s econometric work, which shows that neither wages nor prices tend to lead one another; the wage and inflation process seems to happen simultaneously. So, if we wait for wages to move materially higher, we could be too late in spotting the inflation outbreak.
But there were some unique features of the ‘60s:
- The Vietnam war played a crucial role. US Federal spending (entirely on defence) shot up by over 1% of GDP from mid-1965 to early 1967. The deployment of over 300,000 more troops served to tighten the domestic labour market further. This episode shows it is not a good idea to add stimulus to an economy already at full employment. The stimulus today has been in response to a large amount of slack, with unemployment still relatively high and participation low. We expect the current labour market demand and supply imbalances to be resolved later this year, but there are some risks if Congress passes a large deficit-funded infrastructure package
- Unionisation exacerbated the wage-price spiral. The labour market appears much more flexible today, aided by an increasing number of ‘digital nomads’ or ‘work anywhere’ jobs
- In the ‘60s, the Fed had far less sophisticated understanding of the role of inflation expectations (there was no TIPS market) and was less independent. We are confident that the central bank will take appropriate action, should the current wave of inflation not prove transitory
- The increase in prices was broad-based. This is a clear difference from today, where the median CPI is still behaving well
- In 1966, England last won a major football tournament (though I’m still convinced that the ball never crossed the line on England’s winning goal). This time round, however, we’ll need to wait a few more days to know whether it’s a unique feature of the 1960s or not…
Please continue to utilise these blogs and expert insights to keep your own holistic view of the market up to date.
Keep safe and well.
Paul Green DipFA
29/06/2021