Many market drivers seem to have reached a ceiling. Is this also the case for the equity markets?
The second quarter is already well underway and risky assets continue to outperform bonds and cash by a wide margin. Even if valuation levels in most equity markets seem (too?) generous, the cycle remains favourable for risky assets: global demand, earnings growth and inflation are all firmly on the rise. On this basis, nothing seems to justify a rebalancing of portfolios in favour of defensive assets. But isn't the important thing this famous "second derivative", i.e. the pace of the rise rather than its absolute level? Indeed, the notion of deceleration is often crucial when it comes to anticipating the future direction of equity markets. Below, we review several indicators that may well have peaked in terms of pace of growth.
One caveat; while under blue skies the top of a mountain is visible to the naked eye, this is not the case for the economic cycle and financial markets. It is only when we stroll back down that we know that the peak had indeed been reached. But a review of certain indicators is always a good exercise, so as not to get trapped by the intoxication of the peaks...
U.S. growth to peak in Q2
US GDP grew by an estimated 6.4% in the first quarter. Growth should peak in the second quarter thanks to the most favourable basis of comparison (closure of the global economy in Q2 2020). The trajectory could be similar for the leading macroeconomic indicators. They are currently at record highs on both sides of the Atlantic. If market history is anything to go by, the deceleration of growth from high levels has often proved tricky for equity markets, with poor or even negative performance in the 12 months following the growth rate peak. The "good" news is that there are regions that are lagging the US. For example, the Eurozone saw its real GDP contract by 0.6% on a sequential basis in the first quarter, which should keep the fun going...
Earnings growth in the S&P 500 should peak in the second quarter.
We have the same story for earnings. We are currently in the midst of a earnings season that is proving to be exceptional. Based on a quarter of earnings releases, the S&P 500 earnings growth rate is 33.8% and nearly 85% of companies have beaten expectations. While earnings are expected to continue to grow, the momentum is likely to slow.
Exceptional figures difficult to reproduce for GAFA?
After a strong stock market outperformance in 2020, the time has come for the famous GAFA (Google, Apple, Facebook, Amazon) to take stock. But no disappointment in terms of quarterly results. On the contrary. Amazon has seen its 1st quarter sales increase by 44% compared to last year. With 34% growth, Alphabet – Google's parent company – recorded its highest sales growth in 4 years. At Facebook and Apple, the "top line" growth was 48% and 54% respectively. These are staggering growth rates, which have an ideal basis for comparison, and which will therefore be difficult to replicate in the future.
Buyer flows into equity funds
Since the beginning of the year, flows into equity ETFs have broken all records. Extrapolating from the first quarter figures, we can expect nearly $900 billion in inflows for the year 2021, almost four times as much as in 2020. But this is just an extrapolation. Indeed, it seems almost impossible to replicate the pace of recent months.
The end of the space madness?
The first part of the year was marked by a feeling of euphoria among investors. This appetite for risk was felt in certain market segments, such as SPACs – instruments that allow private companies to become listed much more quickly than through traditional IPOs. The issuance of SPACs broke all records in the first four months of the year. Many hedge funds and private investors rushed to buy these SPACs hoping for substantial profits. But it seems that the SEC in the US has managed to deal a fatal blow to this segment by floating the idea of a change in accounting treatment. Since the beginning of April, the number of SPACs has been in free fall.
A break for retail investors?
One of the characteristics of the pandemic is the extraordinary enthusiasm of retail investors for equity markets. Their influence is visible in the volumes, the instruments and asset classes they prefer (SPAC, options, cryptocurrencies) as well as the platforms they use (such as Robinhood). Another phenomenon is the rise of social networks such as Reddit or WallStreetBets that have become passionate about specific stocks such as GameStop. In recent weeks, we have seen a slowdown in trading activity on the platforms favoured by individuals. And the performance of the stocks most held by this segment of investors has clearly stagnated.
Central bank balance sheet expansion may soon decelerate
The driving force behind the current bull market, central bank liquidity injections are about to start decelerating. As the economy reopens and inflation picks up – however slowly – bond purchases by the four major central banks are expected to fall from $8.5 billion in 2020 to $3.4 billion in 2021 and $0.4 billion in 2022. Certainly, monetary policy will remain expansive, but again, it is all about the second derivative. Recent history (e.g. 2018) has shown us that it is very complicated for central bankers to take their foot off the gas pedal, even if it is only a small deceleration.
A study of the historical performance of the S&P 500 shows that the best performance is obtained during the period starting in November and ending in April (+5.8% annualized). In contrast, the average performance of the S&P 500 between the end of April and the end of October is only +1.7%. This is the famous "Sell in May and go away". If history were to repeat itself, we would have reached the peak of (favourable) seasonality late last week.
What about the equity market?
As mentioned above, some indicators may have already reached their highs in recent weeks. But what about stocks? It is true that the S&P 500's progression since the March 2021 low can be dizzying: almost 80% increase, the 3rd highest in history. But the factors mentioned above are not de facto sufficient conditions to signify the end of the bull market. It is true that we are entering a more mature phase of the economic cycle, which could result in more volatility, more frequent corrections and probably more modest gains than we have seen over the past 12 months.
But in terms of asset allocation, there are few alternatives to equities. Government bond yields have recovered only slightly over the quarter, cash is not paying off and credit spreads are relatively tight. It is also interesting to note that there are opportunities within the equity markets. For example, some stocks should continue to benefit from the end of containment. European equity markets are trading at a significant discount to U.S. markets. So, it seems premature to talk about the descent. Time to enjoy the view from the top!