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Markets test how far to price in an economic boom

The optimism over a prolonged economic boom is gaining traction. This week Jamie Dimon told JPMorgan shareholders that the good times “could easily run into 2023” for the US economy.

Similarly upbeat was an assessment by the IMF that the global economy will expand sharply in the next two years, led by the US and advanced economies.

Such confidence has helped global equities push further into record territory this week. But investors might want to ask: how much of the good news is already factored into stock market valuations?

“It gets tougher for investors during the second year of a recovery, because the stock market is a forward predictor,” said Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management. “There is a lot of optimism about the economy reopening and for additional government stimulus, but the market has largely priced in that outcome.”

One way of gauging how far market sentiment has run is that the S&P 500 is sitting just shy of 4,100 points, the median target for the end of 2021 for the US equity benchmark expected by Wall Street analysts surveyed by Bloomberg. It is a similar story elsewhere, with a global investor shift into companies expected to benefit from a vaccine and stimulus-led restoration of economic activity during 2021.

Europe’s Stoxx 600 has climbed beyond the 435 point level, the median analyst year-end target for the benchmark. Japan’s Topix remains well above its mid-year target of 1,700, although it has retreated a touch from its March peak of 2,000 points. 

The strong performance duly raises the bar for future returns while leaving sentiment exposed to adverse developments. Among the challenges looming, corporate profits need to exceed current estimates to drive further market gains.

Profit growth for the MSCI All World index during 2021 is forecast to rebound 29 per cent, according to analysts at Citi. That leaves the market already trading a toppy 19 times its forward earnings estimate over the next 12 months.

Throwing some sand into the bull market gears is the likelihood of tax increases for global companies, with the Biden administration proposing a new model for levying multinational corporations and a global minimum corporate tax.

Line chart of High quality stocks*, 10-year rolling price returns (%) showing Quality shares are a long term winner

Higher taxes from 2022 as governments seek to offset the cost of their pandemic stimulus efforts and rising input costs is not a good combination for corporate margins.

Another nascent area of concern is the likelihood of tightening credit standards in China knocking European companies and commodity producers. For that reason, Slimmon says MSIM’s portfolios hold cyclical companies in the US that can benefit from a strengthening economy, while they are more defensively positioned in Europe.

Owning lower-quality stocks that stand to gain from a hot economy has been the winning equity strategy in recent months, a trend showing signs of fatigue. A tilt towards owning industrial, financial and tech companies with strong…

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