In our view, since we had upgraded our overall position in equities to overweight near the bottom of the pandemic-driven crash in late March 2020, we have rightly made the case for an equities bull market, which has driven significant outperformance versus our benchmarks.
While we believe that the positive outlook for risk assets remains intact given the broadly positive momentum of the global economic recovery, our view is that the bulk of the easy gains is likely behind us. Therefore, our outlook for markets remains positive although our level of conviction is lower as the risk-reward deteriorates with higher prices.
We are cognizant that global equities have not suffered a significant correction for some time now, and that some technical indicators such as the relative strength index (RSI) and the gold-copper ratio are suggesting that the market is over-bought. Increasing focus on President Biden’s tax hikes, further USD strength, and the normalization of monetary policy in China could also pose tactical challenges for markets.
That said, while there is the potential of a short-term correction, we would not cut exposure as the recovery momentum remains intact, and we believe fading the market against a positive backdrop of improving economic growth would be penny-wise, pound-foolish. Moreover, metrics such as high price-to-earnings ratios are rarely structurally mean-reverting over the near-term. We remain positive over a 12- month horizon, and therefore will see any dips as opportunities to be bought.
The bear argument that all the positives are already priced into the markets does not fully hold water, in our view. While some indicators, such as price-to-earnings ratios (PE ratios) and credit spreads appear stretched versus historical averages, on a relative basis, there is a case to be made that stocks still appear cheap based on the spread between equity earnings yields and real bond yields, and the differential between value and growth stocks’ PE ratios also appear too depressed for this period when economic growth is at the base of a hockey stick pattern.
Over the last week, there has been much market attention on Biden’s proposed increase in the federal capital gains tax rate to 39.6%, which would apply to taxpayers with annual incomes above USD1 million, and would also likely apply to qualified dividends.
Biden’s various proposed tax provisions are expected to result in US government revenues of USD1.8 trillion over 10 years, which will be an integral part of funding his proposed infrastructure bill.
We estimate that a higher statutory corporate tax rate will impact 2022 earnings-per-share of the S&P500 by about USD8-9 per share if raised to 28%, and above USD5 per share if raised to 25%. As for impact on specific sectors, we believe that domestic companies will see the largest impact in terms of effective tax rates from a change in the statutory corporate tax rate. To illustrate, after Trump’s TCJA tax cuts, domestic companies such as energy, financials and consumer discretionary were the largest beneficiaries, and pricing power and industry competition will determine to a large extent whether the tax increases would be absorbed or passed down to consumers.
That said, in terms of year-on-year corporate earnings growth, the impact of a higher statutory corporate tax would be offset by an anticipated robust economic and earnings recovery, elevated corporate cash balance of USD2.1 trillion in sectors ex-financials, and the positive impact of the spending component of Biden’s infrastructure plan.
In terms of the proposed increase in the federal capital gains tax rate to 39.6%, we believe it is possible that Congress will eventually pass a scaled back version of this proposal given the razor-thin margin in the Senate and that the current proposed level will be the highest seen in more than 100 years since the income tax was established. In very broad terms, a ballpark of 28% appears plausible as this is about mid-way from the current rate and Biden’s proposed rate, and we note that President Reagan and a Democratic House had settled on 28% decades ago when raising the capital gains tax from 20%.
In any case, we expect that the discussion will continue to evolve until the Biden administration releases its 2022 fiscal year budget submission to Congress. As for market impact, historically there has been equity weakness in the 6-month period before capital gains rate hikes, but these declines tend to be limited in scope and more than offset by the market appreciation in the 6-month period after the rate hikes.
Within our view, we remain risk-on through our overweight positions in equities, where we have a preference for the US and Asia ex-Japan, and in Emerging Market High Yield bonds, which still offer attractive carry and are a beneficiary of the global search for yield. We are underweight in both Emerging Market and Developed Market Investment Grade bonds, which face headwinds from a steeper yield curve.
Overall, the longer term outlook for risk assets remains favourable given that a vaccine-driven global economic recovery is firmly underway, super-charged by powerful US fiscal stimulus and ongoing support by major central banks, and investors should stay invested through potential near term volatility.
