by Brian Levitt, Invesco Canada
If you follow me on social media, you won’t be shocked to learn that my colleagues and I are bullish on equities. But why? There are several reasons — 10, in fact — which I’ve compiled below.
1. It’s early in the business cycle
Equity markets tend to lead the business cycle, and this cycle appears to have room to run. The last five elongated U.S. business cycles lasted an average of seven years and produced, on average, a cumulative 25% growth in U.S. real gross domestic product (GDP).1 The current cycle is only one year old, and U.S. real GDP is only just returning to where it was at the start of 2020.
2. The economy is hot
Consumer spending,2 business investment,3 and housing4 are all booming at the same time. Leading indicators for the global economy are approaching multi-year highs, suggesting that the economy may grow above trend for the foreseeable future.5
3. A strong economy suggests companies could grow into their valuations
There’s been a lot of hand wringing about valuations, but valuations are almost always elevated one year after a recession.6 However, history informs us that stocks grew into their multiples after every recession since the early 1990s. Leading indicators signal that a V-shaped recovery in earnings growth could be imminent.7 Our research shows that stocks produced consistent double-digit returns during periods of positive earnings growth over the past 31 years, regardless of what multiples did.8
4. Financial conditions are the loosest on record
Interest rates are low,9 the U.S. dollar is relatively weak,10 corporate bond spreads are tight,11 and the equity market is at or near all-time highs.12 Admittedly that all may sound ominous to investors, but historically the time to become concerned has been when financial conditions have tightened meaningfully, and not when they are historically easy.
5. The U.S. Federal Reserve isn’t expected to raise rates until late 2022
In short, don’t fight the U.S. Federal Reserve (Fed). The process of policy normalization may be in the offing, but the Fed is unlikely to tighten policy meaningfully with the “real” unemployment rate, which includes part-time workers and those who are marginally attached to the labour force, still above 10%.
6. Historically, it’s not the first interest rate hike that tends to matter anyway
A review of past initial rate hikes in business cycles (’94, ‘04, ’15) indicates that returns remain robust in the 12 months prior to, and 36 months post, the first interest rate hike, weakening only when the U.S. Treasury yield curve flattens.13
7. The bond market believes the rate of inflation may moderate.
Short-term inflation expectations are above 3%, but 3-year and 5-year inflation expectations are around 2.5%,14 closer to the Fed’s perceived “comfort zone.” If accurate, then near-term inflation that’s supportive of corporate earnings, followed by moderating inflation pressure that allows the Fed to maintain policy support, feels like a very favourable backdrop for risk assets.
8. There is capacity in the economy to increase production.
Businesses are not only looking to rehire to match the growing demand15 but are also investing to rebuild inventories16 and improve productive capabilities, both of which should suppress inflation concerns. Capital expenditures are back to pre-pandemic levels.17 The “real” unemployment rate, which includes part-time employees and those who are only marginally attached to the labour force, stands at 10.2%, suggesting that the economy isn’t close to full employment.18
9. There’s a lot of money on the sidelines.
There is $20 trillion USD total in cash, checking deposits, savings deposits, and other “near money.”19 While investors focus on goods inflation, it is reasonable to expect that “too much money, chasing too few assets” could result in asset price inflation.
10. Investors are not euphoric about equities.
It is said that market cycles tend to end in investor euphoria. Investors, since the global financial crisis, have allocated over $3 trillion USD into bond mutual fund and ETF strategies and over $1 trillion USD into money market strategies. On the other hand, investors have only allocated a cumulative $550 billion USD to equity strategies.20 It appears there’s space to go before investors appear “euphoric”.
As my colleague Talley Leger opined, “the best may be yet to come.”
1 Sources: Bureau of Economic Analysis, Bloomberg, Invesco, March 31, 2021, latest data available
2 Source: U.S. Census Bureau, as represented by U.S. Retail Sales, May 31, 2021
3 Source: U.S. Federal Reserve, as represented by Total Capital Expenditures, March 31, 2021, latest data available
4 Source: U.S. Census Bureau, as represented by U.S. New Only Family Houses Sold, April 30, 2021, latest data available
5 Source: Conference Board, as represented by Conference Board U.S. Leading Index Ten Economic Indicators, April 30, 2021, latest data available
6 Sources: Bloomberg, L.P., Standard & Poor’s
7 Source: Institute for Supply Management. Analysis compares the correlation between the ISM Manufacturing Index and S&P 500 Index earnings per share.
8 Sources: Bloomberg, L.P., Standard & Poor’s, Invesco, as of March 31, 2021, latest data available
9 Source: Bloomberg, L.P., as represented by the 10-year U.S. Treasury rate, May 31, 2021
10 Source: Bloomberg, L.P., as represented by the U.S. Dollar Index (DXY), which indicates the general value of the U.S. dollar against a trade-weighted basket of currencies
11 Source: BarclaysLive, as represented by the Bloomberg Barclays U.S. Corporate High Yield Bond Index option adjusted spread, May 31, 2021
12 Source: Bloomberg, L.P., as represented by the S&P 500 Index, May 31, 2021
13 Sources: Bloomberg, L.P., U.S. Federal Reserve, Invesco. Returns are represented by the S&P 500 Index, May 31, 2021.
14 Source: Bloomberg, L.P., as of May 31, 2021. The breakeven is the difference between the nominal yield of the 1-year U.S. Treasury and the yield of the 1-year Treasury Inflation Protected Security.
15 Source: Bureau of Labor Statistics, as represented by U.S. Employees on Nonfarm Payrolls, May 31, 2021
16 Source: Institute for Supply Management, as represented the ISM Report on Business Inventories, May 31, 2021
17 Source: U.S. Federal Reserve, as represented by Total Capital Expenditures, March 31, 2021, latest data available
18 Source: Bureau of Labor Statistics, as represented by the U6 Unemployment Rate, May 31, 2021
19 Source: Bloomberg, L.P., May 31, 2021. Near money is defined as assets that can be readily converted into cash.
20 Sources: Bloomberg, L.P., Investment Company Institute, May 31, 2021
This post was first published at the official blog of Invesco Canada.
