Global equity markets have continued to break new ground this year, but could the bull market that started in 2009 be coming to an end? Equity valuations are at peak levels with measures such as the GDP to market cap ratio at an all-time high. Earnings growth remains strong, but we are seeing signs of fatigue and momentum has started to slow. Part of the reason for this is technical, with comparable earnings set to get more difficult from here. Inflation and supply constraints are also playing their part, although the latter is likely to mean that growth is being delayed rather than declining and is reflected in robust earnings growth estimates for next year.
Inflation expectations are likely to remain a key influence on markets as we head into next year. Currently, inflation expectations are elevated, especially in the US, but with inflation-hedged bonds still showing negative real yields, the bond market is indicating that it is transitory and suggests that interest rate rises are likely to be modest. Any change to the belief that inflation is transitory could result in interest rates rising faster than expected creating a real risk for the global economy and global equity markets.
As we emerge from the pandemic, it is worth considering where we are now. For us, there are two historic periods that provide some interesting parallels. The first was the immediate post-World War II boom which saw economies rebuild their infrastructure and transition from the production of military and industrial goods to consumer goods and services. The other is the era of stagflation in the early 1970s when the post-World War II economic boom gave way to a period of economic woe as wages stagnated and inflation rose, compounded by rising oil prices.
It is important to note at this point that we are not suggesting there will be an economic boom similar to that after World War II or an economic stagflation similar to that in the 1970s. But there are features of both periods that are similar to the current situation. For us, it is the transitionary nature of the post-World War II environment that offers the most compelling parallel.
We are emerging from a crisis which has, in many ways, changed how people behave and what is most important to them. The surge in working from home has undoubtedly raised the importance of having a better work-life balance and has tempted some to leave their city apartments and head for more space in the country or the suburbs for a better quality of life. It has also severely disrupted consumption (alongside the pandemic) of services such as entertainment, restaurants, etc, in favour of spending on household goods or renovations, which continues to increase.
Automation is likely to be another beneficiary of the economic transition. We have already seen an acceleration of this trend, but we expect it to continue due to the increasing scarcity of labour in lower-paid jobs. As countries, such as the UK, transition towards having a higher-skilled, higher-paid workforce, the demand for automation should grow. This will not happen overnight, however, but it provides a nice structural tailwind for companies that provide these solutions.
The transition to a more sustainable economy also continues to represent an exceptional investment opportunity. Embracing sustainability is not just about avoiding risks, it is also about finding opportunities. Companies which play an active role in adapting to and mitigating some of the greatest environmental and social challenges that we see today are likely to be doubly rewarded, enjoying robust growth in demand while further benefiting from future policy and legislative action to promote sustainable development.
ESG characteristics should thus be a consideration for every investment decision: investors should avoid thinking of ESG as a theme which applies only to a narrow set of opportunities. Indeed, such a limited focus led to the valuation of some of the more charismatic sustainable investments detaching from their underlying fundamentals in 2021 as naïve flows into “ESG assets” chased a common core of opportunities. Particularly in a value-led, inflation-conscious equity market, investors should also look beyond these frontline sustainable investments – renewable energy, for example – and consider companies which are transitioning to become sustainable, or who will play a role in supporting the adaptation to climate change or enhancing economic inclusion. For example, extreme weather events will prompt more focus on the stability of the power grid and likely lead to increased consumer investment in off-grid power solutions. On the social side, fintech solutions may help address long-standing inequities.
The sensitivity of markets towards inflationary expectations and interest rates is likely to remain high, which could lead to some significant, short-term factor swings and keep volatility at an elevated level. This provides opportunities for active investors with diverse portfolios to generate alpha by taking advantage of short-term price swings to build exposure to sustainable companies with structural tailwinds that should grow regardless of the market environment. In a transitional inflationary environment, equity markets will do well.
Geir Lode is head of global equities, international business at Federated Hermes.
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