Capital Market Outlook ( December 7, 2020)

IN THIS ISSUE:

  • Macro Strategy—The recent surge in corporate profits to a new record in the third quarter has validated the equity market rally and significant narrowing of credit spreads since March, putting to rest suspicions of a disconnect between financial market conditions and economic fundamentals. In our view, with strongly rebounding real gross domestic product (GDP)/corporate revenues and little cost pressure from interest rates and labor, as well as a likely strengthening productivity trend, profits are likely to advance strongly in 2021. We believe this should help sustain the S&P 500 index while the rotation into more cyclical and Value areas of the equity market gathers steam.
  • Global Market View—Recently, encouraging news regarding the progress of a vaccine has bolstered expectations of a path toward economic normalization in 2021. Despite the global equity rally, international equities remain historically undervalued compared to those in the U.S. Going forward, consider adding to international equities in long-term multi-asset portfolios, especially in those that are substantially underweight the asset class relative to strategic weights.
  • Thought of the Week—Cyclical sectors led the strong market rally last month, as vaccine optimism and reduced election uncertainty improved both market and business sentiment. Stronger business confidence is also behind one of the quickest Mergers & Acquisitions (M&A) recoveries in decades. In contrast to prior recessions, when M&A has taken years to return to pre-crisis levels, deal activity has rebounded sharply in the second half of 2020.
  • Portfolio Considerations—With vaccine advancements and distribution coming closer into focus and consumer pent-up demand building rapidly, we expect a more robust outlook for the economy and private sector profits in 2021 than the consensus currently expects. We would use any weakness in equities as a buying opportunity in order to better position portfolios for the next long-term move up.

Profits Surge Validates Financial-Market Ebullience

A recent streak of red-hot data, such as October business durable-goods orders and shipments, housing starts, consumer spending, as well as U.S. productivity and profits growth, have confirmed our expectation for better-than-consensus growth momentum through the end of 2020. As a result of GDP-boosting incoming data, the Atlanta Fed GDPNow forecast for Q4 real GDP has been significantly raised from about 3% to 11% annualized quarterly growth (following an unrevised 33% gain in the Q3, according to the Bureau of Economic Analysis).

Strong corporate revenue and profits growth, a big increase in new orders booked for October, a nearly two-decade-high Institute for Supply Management (ISM) manufacturing new-orders index, and elevated small-business plans to expand inventories point to continued strong business production and investment. This is important because faster investment will help offset some of the cooling in consumer-goods spending from its redhot pace of the past six months. Overall, we expect 4% to 5% real GDP growth in 2021, which would more than reverse the estimated 3% pandemic-related drop in economic activity this year.

The strong rebound is global, and, according to the November 28, 2020, BofA Global Research library of proprietary indicators, it continued to gain momentum in November, with potential for further upside given a broad-based increase in leading indicators, such as global industrial confidence, global consumer confidence, and soaring global profits revisions ratios ("with upgrades outnumbering downgrades in every region, most global sectors, and all global styles"). The exception to this uptrend are the pockets of weakness coming out of Europe, where new shutdowns are temporarily constraining the services sector in particular.

With U.S. growth and income much better-than-expected, an uptrend in the global manufacturing cycle, and the dollar easing, it is not surprising that Q3 U.S. corporate revenues have strongly surpassed expectations, with an 8% quarter-to-quarter gain, the biggest since 1996. This jump helped revenues recuperate half of their losses incurred in the first half of the year and greatly contributed to the massive upside profits surprise in Q3.

Encouragingly, revenue growth appears likely to remain favorable for profits ahead, with a probable gain of 8% to 10% in 2021 (after declining about 5% in 2020) to new highs sometime in the second half of 2021. This assumes declining uncertainty from still very elevated levels, some moderation in the ISM manufacturing index closer to its long-term average, a gradual further dollar depreciation, and steady-to-higher consumer and smallbusiness confidence.

Stronger manufacturing conditions than we assume are possible given the abovementioned breadth of improvement in economic conditions as the global economy responds to massive government stimulus and pent-up demand. On the other hand, consumer and small-business sentiment have declined into Q4, and downside risks to confidence have increased given the surge in coronavirus cases and concerns about potential growth-constraining policy changes ahead. Continued deterioration on these fronts would restrain our real GDP and corporate revenues estimates.

So far, the combination of a decades-high pace of revenue growth with a big margin expansion (Exhibit 1) has boosted Q3 pre-tax profits as measured in GDP accounts by an eye-popping 27% quarter-to-quarter, to a new record. The strong profits rebound from the shutdown clearly shows that the effect of the global government support has been widely and massively underestimated. So has the combination of pent-up demand and the role of operating leverage in supercharging margins and profits at the beginning of new business cycles.

Exhibit 1: Profit Margins Surged to Trend, As They Typically Do When New Economic Expansions Begin.

Looking ahead, the government stimulus is likely to continue to shape the economy for about another year or so because of the lags involved between changes in policy and their effects on economic conditions. In addition, as noted in past reports, we believe that there are fundamental reasons why profit margins are likely to continue to surprise to the upside, even as they appear high by the experience of the past 40 years.

First, margins usually drop sharply when expansions mature, interest rates increase, and recessions approach, not when new expansions begin. Low interest rates and low energy prices should remain supportive of margins until later in the expansion. For example, our analysis suggests that it would take a sharp increase in real interest rates to meaningfully depress domestic profit margins from current levels, which would run counter to the Federal Reserve's (Fed) stated interest-rate policy intentions two years out. While an eventual increase in real interest rates would be normal, the lags involved between real interest rates and margins are long and unlikely to substantially depress demand and margins in the next year or two. Also important, while some margin compression is probable from elevated current levels in coming quarters, strong revenue growth should mitigate some of this moderation, keeping profits on an uptrend, in our view.

The drop in the labor-force participation rate should also continue to keep the share of labor compensation low by historical standards, buoying margins. Our expectations for a strengthening trend in productivity and soft labor costs also suggest that margins are unlikely to come under much downside pressure over the next two years. Importantly, sustained rapid productivity growth would not only help keep unit labor costs in check but would also prevent the Fed from raising interest rates enough to cause a sharp increase in the real rate, which, as noted above, would be highly detrimental to margins.

As discussed in our March 2, 2020, Chief Investment Office Capital Market Outlook on productivity, economists have been baffled by the secular stagnation caused by the weak productivity growth of the 2010–2016 period and have been equally surprised by its recent improving trend. Expectations for persistent productivity weakness have caused a constant underestimation of U.S. potential GDP growth and an overestimation of inflation. In contrast, our analysis has long suggested a new productivity uptrend, and we continue to expect productivity growth to fluctuate around a likely 3% trend over the next two to three years. Basically, that's because the economic, financial, confidence, regulatory and tax backdrops over the past four years have reversed in favor of a stronger productivity-growth trend. Demographics and dollar trends, which affect productivity with a lag, have also turned in favor of a sustained period of stronger productivity. A sustained productivity shift, as we expect, would have important implications for inflation, interest rates, margins and profits.

So far, the productivity and inflation data have validated our expectations. Despite much skepticism, non-farm productivity growth has continued to surprise to the upside this year, rising 2.9% year-over-year (YOY) in Q2 and 4.1% in Q3. This comes after a gain of 1.7% in 2019 (which was close to its past 40-year average pace of 1.9% even though the manufacturing sector was in recession) and compares with a 0.7% average between 20102016 and 1.5% between 20162019. October inflation numbers were softer than consensus expectations but in line with our long-held view that a strengthening productivity trend, weak wage pressures, and gradual dollar depreciation should keep inflation below 2% into late 2021, monthly volatility notwithstanding.

With productivity strong, inflation and labor costs contained, interest rates at rock-bottom levels, and demand soaring out of the shutdown, domestic profits surged 32% quarter-to- quarter to a fresh record in Q3, up 6% above pre-coronavirus levels. If productivity and margins remain in a high range over the next two years, as we expect, domestic profits have the potential to advance about 12% in 2021 to new records after an estimated 4% drop in 2020.

The rebound in foreign profits has lagged that of domestic profits through Q3. While domestic profits surged to a new record high, foreign profits were still 14% below their pre-pandemic level. However, they are very sensitive to improvements in global manufacturing and trade activity as well as changes in the dollar, so we would not be surprised to see foreign profits taking the lead in 2021, with 20% to 25% growth to fresh highs.

All in all, the positive drive of the incoming economic data has continued to boost equities and reduce credit spreads in recent weeks. The surge in corporate profits has been particularly noteworthy, validating our expectations for sustained high and rising margins and better-than-consensus profits growth, and showing that the market rally since March has made sense.

Market and M&A Rebound the Fastest in Decades

Last month the Dow Jones Industrial Average joined other U.S. equity indexes in fully regaining losses from the coronavirus-induced bear market. November 16 marked 193 trading days since the Dow's peak in February, the fastest recovery from a bear market (price decline of -20%) since 1991. (The S&P 500 took just 126 trading days to recover, the fastest on record.) Price returns in November for the Dow of +12% were the highest in 33 years.

Cyclical sectors led the strong market rally last month, with Energy shares up 27%, Financial shares up 17%, and Industrials up 16%. Vaccine optimism and reduced election uncertainty have improved both market and business sentiment, despite rising coronavirus cases and higher hospitalization rates. Indeed the National Federation of Independent Business (NFIB) Small Business Optimism Index has rebounded to near pre-crisis levels.

Overseas, a similar dynamic has unfolded, with Europe's Stoxx 600 Index and Japan's Nikkei Index leading global equity performance in the past month. These indexes tend to be more leveraged to global growth and to sectors more sensitive to the business cycle.

Improved business confidence is also behind one of the quickest M&A recoveries in decades. As shown in Exhibit 5, global M&A volumes declined during April and May but moved sharply higher during the second half of the year. In contrast, during past recessions, M&A activity has taken years to return to pre-crisis levels. Adding to the momentum, in the past week two large-cap acquisitions were announced, both of which rank in the top ten transactions by deal value year-to-date according to Bloomberg.

In terms of other firm uses of cash, S&P 500 dividends continued to decline in Q3 and were down 8% from their all-time peak in Q1 2020. Meanwhile, cumulative corporate buybacks tracked by BofA Global Research are down 57% YOY.

Improving firm profits due to a faster-than-expected economic recovery should continue to support equities into 2021, and we would consider any pullbacks as buying opportunities. An improvement in dividend trends could also provide support for the markets.

Exhibit 5: M&A Rebound-The Fastest in Decades

Turning Fundamentals

After hitting its highest level since July 2018 in October, Markit's Eurozone Manufacturing Purchasing Managers index (PMI) registered a reading of 53.8, above 50. Retail sales volumes have also recovered, registering a YOY result of 4.3% in October. Government programs across the region, designed to cover the better part of wages for employees who can't work, have kept unemployment in relative check while helping boost the growth of the bloc's liquid money supply to elevated levels., Meanwhile, while still negative on a YOY basis, monthly global trade volumes have risen at a historic average clip of 4.3% from June to September. With total trade comprising roughly 88% of the eurozone's economy, we believe this is welcome news.

Progress in producing an effective vaccine may raise longer-term optimism, sustaining a recent improvement in capital expenditures (capex), in our view. In Japan, machine tool orders, seen by analysts as a leading indicator of corporate capital spending, are picking up. In May, orders were down over -52% YOY but have since recovered to a relatively marginal decline of just -6.0% in October. This is the slowest rate of contraction in nearly two years. Exports are also close to registering positive YOY growth, rebounding from 28.3% in May to down just -4.9% in September.

Comprising nearly 68% of the MSCI Emerging Markets Index, more effective tactics to combat the coronavirus and a general rise in goods trade have benefited China, Taiwan and South Korea, in our opinion. In addition to the region's technological prowess, BofA Global Research estimates that China's economy will grow by 8.5% next year. Possibly observing a spillover effect, after the United States, Japan and South Korea rank second and third in total trade with China.

These favorable developments argue for an improving fundamental backdrop. With 2020 expected to mark a second consecutive year of shrinking annual earnings per share (EPS), next year the consensus expects EPS to grow over 20% across these markets (Exhibit 3). According to the Global Earnings Revision Ratio, published by BofA Global Research, November saw analysts' expectations soar, with earnings upgrades now outnumbering downgrades across international markets in the latest one-month reading, joining the U.S. (Exhibit 4).

Exhibit 3: Strong Earnings Expectations for Next Year Have Stabilized After Dropping Due To The 2008 Global Recession. Earnings-per-share growth (%)

 

2018

2019

2020E

2021E

S&P 500

20.9

1.0

-14.7

21.6

MSCI Japan

6.4

-13.9

-29.4

29.0

MSCI Europe

-0.1

-2.1

-27.1

30.7

MSCI Emerging Markets

1.0

-14.1

-9.6

31.4

E=Estimate. Source: Factset. Data as of November 30, 2020. Forecasts are subject to change. Past performance is no guarantee of future results.

Exhibit 4: The U.S. Remained A Leader, But Rising Earnings Trends In International Markets Strengthen The Case For The Diversification Of Corporate Income Streams For Equity Investors.

In the Eye of the Beholder

Encouragingly for the European Union, the incoming U.S. administration places greater value on alliances—viewing tariffs on America's transatlantic partners, among other nations, akin to disabling the coalition's economic clout—which could be used as leverage to sway issues of geopolitical importance.8 Vowing to rejoin the Paris Climate Accord, a Biden presidency would see shared agendas with China in the areas of climate change, nonproliferation and global health security. These views would suggest more consistent U.S. foreign policy, which may improve the longer-term business outlook and sustain global capex.

In Japan, new Prime Minister Yoshihide Suga has promised to build on "Abenomics"―an economic policy platform whereby fiscal and monetary policies are coordinated. Meanwhile, reduced diplomatic turbulence with its allies would allow EU officials to focus their energy on further reforms, such as harmonizing capital markets and/or establishing a banking union, in our view. The Biden administration's disapproval of a Brexit deal that endangers peace between the Republic of Ireland and Northern Ireland may complicate the U.K.'s push for a trade accord with the U.S. This would compound the costs of damaging tariffs on U.K. exports to the EU, in the case of an adverse or no deal. While this plight for the U.K. marginally bolsters our base case for a deal that largely avoids these costs, risks have risen, tempering our conviction on this call.

In the eye of the more cautious investor, near-term, inauspicious elements persist. A second major wave of the coronavirus has hit Europe, prompting an increase in social restrictions. Though generally less harsh than those implemented earlier this year, they are still dampening the region's economic recovery, according to certain high-frequency indicators. If they were to proliferate and/or become prolonged, deep economic scarring may result, even with furlough subsidies in place, according to the European Central Bank. Concurrently, despite an agreement in principle on a €750 billion recovery fund to spur the bloc's economic recovery, haggling over rule-of-law conditionality governing the disbursement of the funds remains a hurdle for a decisive pan-European fiscal response.11 Comprising nearly 18% of nominal global GDP, prolonged economic weakness in the EU may raise uncertainty, undermining the recent pickup in global trade and capex.

In addition, major EMs, such as Brazil and South Africa, contend with worsening public fiscal dynamics, which may hamstring greater stimulus to drive their economic recoveries. We also think that deficient healthcare systems may delay vaccine dissemination in some countries. Despite the potential for greater predictability in U.S. foreign policy, bipartisan hawkishness in Washington toward China is likely to persist, impeding more receptive relations between both superpowers, in our view. Nations such as Japan and Canada will likely need to delicately balance their foreign policy position to avoid alienating either titan, representing either a major trading or security partner.

Portfolio Strategy

A balance between secular Growth leaders and higher-quality cyclical Value stocks, underpinning our view of a global economic recovery over the coming quarters, is our preference. This stance underpins our more constructive view on international equities. According to MSCI, Financials and Industrials, sectors with larger characteristics of cyclical value, comprise only a 9.5% and 8.2% share of the USA index, respectively. In contrast, Industrials comprise 20.3% of Japan's index, while Financials make up 14.3% of Europe's. EMs may also benefit from a pickup in global trade. Consider adding exposure to these regions in long-term multi-asset portfolios, particularly if they are significantly underweight relative to U.S. equities.

Market and M&A Rebound the Fastest in Decades

Last month the Dow Jones Industrial Average joined other U.S. equity indexes in fully regaining losses from the coronavirus-induced bear market. November 16 marked 193 trading days since the Dow's peak in February, the fastest recovery from a bear market (price decline of -20%) since 1991. (The S&P 500 took just 126 trading days to recover, the fastest on record.) Price returns in November for the Dow of +12% were the highest in 33 years.

Cyclical sectors led the strong market rally last month, with Energy shares up 27%, Financial shares up 17%, and Industrials up 16%. Vaccine optimism and reduced election uncertainty have improved both market and business sentiment, despite rising coronavirus cases and higher hospitalization rates. Indeed the National Federation of Independent Business (NFIB) Small Business Optimism Index has rebounded to near pre-crisis levels.

Overseas, a similar dynamic has unfolded, with Europe's Stoxx 600 Index and Japan's Nikkei Index leading global equity performance in the past month. These indexes tend to be more leveraged to global growth and to sectors more sensitive to the business cycle.

Improved business confidence is also behind one of the quickest M&A recoveries in decades. As shown in Exhibit 5, global M&A volumes declined during April and May but moved sharply higher during the second half of the year. In contrast, during past recessions, M&A activity has taken years to return to pre-crisis levels. Adding to the momentum, in the past week two large-cap acquisitions were announced, both of which rank in the top ten transactions by deal value year-to-date according to Bloomberg.

In terms of other firm uses of cash, S&P 500 dividends continued to decline in Q3 and were down 8% from their all-time peak in Q1 2020. Meanwhile, cumulative corporate buybacks tracked by BofA Global Research are down 57% YOY.

Improving firm profits due to a faster-than-expected economic recovery should continue to support equities into 2021, and we would consider any pullbacks as buying opportunities. An improvement in dividend trends could also provide support for the markets.

Exhibit 5: M&A Rebound-The Fastest in Decades