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Stock Market Monitor: Q4 2021 equity market outlook

28-Sep-2021
  • Nigel Bolton

Equities remain good value. We believe strong corporate earnings coupled with ultra-low bond yields suggest equities are not overpriced. Yet the synchronized COVID-relief surge since November 2020 is over and investors must be more discerning and select companies that can beat earnings expectations. Our view leading into year-end:

  • Equities still offer value even as markets nudge new highs
  • Expect more differentiation between winners and losers both within sectors and regions
  • Engaging with companies on sustainability can unlock shareholder value

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Equity valuations may fall further over the next 12 months but we believe stock markets may deliver high single-digit total returns, underpinned by strong earnings and dividend growth.

Company earnings forecasts were upgraded by analysts at the end of the first quarter of 2021. And still, around 85% of companies in the S&P 500 Index and 65% in the Euro Stoxx 600 Index beat earnings expectations in the second quarter – well above historical averages. Companies retained cost controls necessitated by the COVID-19 pandemic and produced exceptionally strong revenues – especially in those sectors most closely linked to the economic recovery. These earnings results helped drive stocks to new highs.

Comparing equities and bonds
Equity risk premium for global stocks, 1991-2021 

 

Source: Refinitiv DataStream, MSCI, and BlackRock Investment Institute, September 2021. The chart shows the equity risk premium – the difference between the estimated real return on stocks and the estimated real return on “safe” bonds – for the MSCI World Index. This is calculated by subtracting the real U.S. bond yield from the earnings yield. The U.S. real bond yield is calculated by subtracting U.S. inflation from the 10-year Treasury yield. The earnings yield is the inverse of the MSCI World 12-month forward price-to-earnings ratio. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Where can stock markets go from here? The increase in earnings expectations means equities are cheaper now than they were at the start of the year. This is the case on both a price-to-earnings basis and according to the “equity risk premium,” which measures the earnings yield of equities versus government bonds, where yields are around all-time lows. See the chart above. Yet the period of synchronized stock market resurgence that followed the COVID-19 shock in 2020 is over, in our view. The key now is to find those companies that can deliver earnings above analyst expectations.

global profit margin forecasts

Source: Bloomberg, MSCI, September 2021. The chart shows the 12-month trailing profit margins for companies in the MSCI USA Index, the MSCI Europe Index and the MSCI Asia excluding Japan Index. The dotted lines are profit margin forecasts from Bloomberg. It is not possible to invest directly in an index. There is no guarantee any forecasts made will come to pass.

Riding out inflation

Inflation is a persistent market concern – yet higher costs don’t always mean lower profit margins.

Prices and profits

We may see higher inflation over the medium term. Costs are rising as economies open up and consumer spending surges, while supply remains limited due to COVID-related disruptions. We are seeing an imbalance between demand and supply for labour across many industries leading to upward wage pressure. Rising input costs mean there is potential for profit margins in certain sectors to come under pressure. Automaker CEOs tell us that semiconductor supply may get worse before it gets better. The logistics industry is struggling with a shortage of truck drivers. And consumer staples companies are feeling the strain of high prices in soft commodities such as sugar, alongside increased freight and labour costs.                                                

But because current inflation is largely explained by the implications of national lockdowns and supply chain disruptions, we expect most cost pressures will eventually ease. Overall, we expect company profit margins to remain resilient during an inflationary period, with net margins in 2021 demonstrating potential to exceed pre-pandemic levels. See the chart below. And while we will be closely monitoring labour market shortages, U.S. profit margins have historically risen alongside changes in annual wage inflation as economies grow. Yet it is critical for equity investors to identify companies that can control their profit margins and reinvest in their business to maintain a competitive advantage and drive earnings growth over time.

Great expectations
Global profit margins and margin forecasts, 1999-2023

Three sectors and a region

The companies that can ride out inflation and grow market share into 2022 and beyond will come from a range of sectors, industries and regions, in our view. Opportunities we would highlight:

Technology: COVID has accelerated digitization trends that were already evident across industries. Sellers of digital advertising space should continue to grow rapidly as marketing budgets expand in an increasingly e-commerce-driven world. Cloud computing is critical to the digital transformation and still represents only 0.25% of global GDP, so we see opportunities for investors here despite high prices. Cyber security is another area of strong growth as flexible working brings new risks.

Industrials: Suppliers of factory-automation solutions should benefit from higher demand as developed market workforces age, labour costs rise, and as companies look to strengthen and shorten supply chains.

Consumer discretionary: Some of the luxury names remain attractive to us, and recent market wobbles provide a compelling entry point.

Europe: Investors should also pay attention to regional allocations. Europe – including the U.K. – is ahead of the U.S. on vaccination rates, the Delta COVID variant has only dented rather than derailed the recovery, and stock market valuations remain low versus the U.S.

Key takeaway: Expect winners and losers to emerge within sectors and regions as companies seek to maintain strong earnings growth this year and into 2022. We believe companies that can boost their competitive advantage, control margins and pass on cost increases have the best chance of beating expectations and delivering strong returns.

Sustainability spotlight: the power of engagement

We are forward-looking investors at BlackRock Fundamental Equities. Our job is to assess the future financial performance of companies and decide whether to allocate client money to those companies. Alongside our financials and fundamentals analyses, we scrutinize environmental, social and governance (ESG) factors to understand how a company has considered sustainability-related risks – including climate risk – in its business model. We leverage BlackRock’s resources in support of these efforts, including BlackRock Investment Stewardship’s (BIS) engagement insights. 

Examples of ESG engagement:

  • Encouraging a refocus on unique opportunities. Some conglomerates not known for their ESG credentials contain energy efficiency businesses within their broad enterprise. In these instances, we have encouraged a refocus on these initiatives, emphasizing that markets are increasingly rewarding facilitators of the energy transition.
  • Advocating for change from within. We have encouraged companies in “dirty” industries such as cement and steel to publish plans to lower carbon emissions. We would rather these companies change from within than sell ESG-unfriendly assets to the private sector. A higher ESG rating for these companies could then be rewarded in the share price.
  • Emphasizing value of strong human capital management. We encouraged theme park owners to give seasonal staff a higher wage and benefits. Happier workers – even those who only represent the company briefly – could become better representatives of the company brand.

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Nigel Bolton
Co-Chief Investment Officer of BlackRock Fundamental Equities