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Quarterly Market Outlook: October 2021

Full recovery faces temporary bottlenecks (COVID-19)

Supply chain bottlenecks and SARS-CoV-2 (COVID-19) a variants are having an impact in lowering short-term economic growth, but pent-up demand and favorable financial conditions continue to support the path to full recovery.

The global economy is transitioning from a policy-induced economic recovery to an organic and self-sustained expansion. Central banks have so far been successful in communicating to the market a path towards less monetary accommodation and have avoided a "taper tantrum". Current negative real yields in developed markets imply a benign path for both inflation and future monetary policy, although that is looking increasingly less likely.

High valuations in risky assets are increasing the fragility of the market. We highlight four risks that could bring volatility in the coming months: (i) Inflation, (ii) Chinese property market, (iii) margin compression for companies as costs increase, and (iv) fiscal policy uncertainty in the US. However, we believe the bullish uptrend in equities and credit is still supported by relative valuations, improving corporate earnings, and a still-accommodative monetary policy environment.

01. Mixed messages on the economic radar

Investors are caught in the crosscurrents of inconsistent economic data and contradictory trends. Global difficulties in bringing COVID-19 cases under control is changing business expectations of a rapid economic revival, forcing companies to reset plans and revise forecasts. Still, household finances remain in good shape thanks to generous government stimulus programs in developed economies and global financial conditions are very favorable for companies to invest. 

In the two graphs below, we can see the mixed signals coming from the hard economic data. Measures of economic “surprise” in activity indicators (i.e., a comparison of official data with economists’ forecasts) started to deteriorate and turned negative during the summer. On the other hand, inflation data been higher than forecasts globally.

Investors are concerned about the current trend of higher inflation and lower economic growth

Almost 18 months have passed since the beginning of the pandemic and the economy is gradually on the mend. According to Our World in Data, which compiles all data available in the world regarding COVID-19, the share of population with at least one dose is over 40%, with the European Union at 65%, the United States at 62%, South America at 56%, Asia at 46% and Africa at 5.5%. The graph below shows that, while it is true that new infections generally declined around June, the emergence of the Delta variant was responsible for more than 90% of new infections in the United Kingdom and has led to new peaks of infections in most countries and regions.

02. Policy support continues in 2021, but it's a different story for 2022

Governments are beginning to pull back the generous support they provided earlier in the pandemic, but both monetary and fiscal policy stance continue to be accommodative in 2021.  Markets are still extremely dependent on monetary stimulus. So, there is a growing risk that higher inflation exacerbated by ongoing supply chain friction could cause a dent in demand next year.

Policymakers and economists are paying more attention to longer-term inflation expectations which have remained anchored in both Europe and The United States, allowing, both the Fed and the ECB to look through these temporary swings in inflation. In all cases, inflationary dynamics are unlikely to impact Fed policy over the near-term. Instead, the speed of the labor market recovery will probably dictate the Fed’s liftoff date.

Despite the spike in headline inflation bond markets remain calm even as tapering is approaching

Central bankers, just like companies, governments, and health services, are struggling to answer the question of what “normal” will look like after the pandemic. The answer is crucial to determine how fast the exit strategy will be implemented implemented, with the first step being to slowly turn off the flow of asset purchases, known as “tapering”. As we can see in the graph on the previous page, the process of tapering created some turbulence in the previous cycle (the taper tantrum of 2013) with a spike in global bond yields. Currently, government bond spreads remain narrow.

03. Strong earning and improved financial conditions continue to support risky assets

The odds that global economy will experience a recession before 2023 are low as fiscal and monetary policy are still supportive, and households in many countries hold historically high levels of savings. Despite the slow progress of immunizing against the virus, the general trend of fewer restrictions on activity likely implies a continued broadening of the global economic expansion over the course of the next year.

Earnings estimates in all regions apart from the UK have recovered and surpassed prepandemic levels. Analysts and companies have been much more optimistic than normal in their estimate revisions and earnings outlook for the third quarter to date. As a result, expected earnings for the S&P 500 for the third quarter are higher today compared to the start of the quarter. 

European and US equity market multiples have not gone up as earnings growth has surpassed price appreciation

So what’s next for markets? There are reasons to believe that the upswing is still intact given the fact that the economic recovery is ongoing, but valuations seem to have reached the point of exhaustion and as a result, markets are more susceptible to negative surprises. We have highlighted four potential catalysts for a risk-off event in the coming months: (i) Further spike in the electricity crisis causing concerns of inflation and lower growth, (ii) A compression in corporate margins because of supply chain bottlenecks and rising producer prices, (iii) A deterioration in liquidity within the Chinese real estate sector and, (iv) Potential turmoil in the US Congress as a result of negotiations over the president’s spending plans and the need to raise the debt ceiling.

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