Why the reopening of economies could be difficult for cyclical stocks

It’s a slightly odd feeling. When you have experienced such an intense period of living differently from what you are used to, any consequent change, although hugely positive, can be slightly unsettling.

The easing of restrictions in many parts of the world brings with it differing opinions. Will we simply go back to our normal way of life, commuting to an office and spending more as many have boosted their savings during the global lockdowns? Or will we still be fearful to re-enter the post-lockdown world, tiptoeing carefully, wary of new Covid-19 variants and more pandemic waves?

Judging by events in some countries, people are excited to be re-engaging in social activity, which is heart-warming after the historic period we have all lived through.

Over the past few weeks, stock markets have been similarly buoyant, hitting new highs across the world. The broadest measure of stocks in the world’s premier economy, the S&P500 seems to hit fresh records every week or so, while the more volatile technology-heavy Nasdaq index is once more closing in on its highs.

Even in Europe, where lockdowns are still ever-present and the vaccine rollout has been slower, Germany’s major stock market churned out an impressive 9 per cent gain in the first quarter of this year. This has been primarily driven by bank stocks, which investors have been hungry for as bond yields rise and potentially lift banks’ profits in the process.

It seems that the only thing that matters to asset prices is central bank largesse. This bounty, from people not normally associated with bearing gifts, is not a new feature, of course, but it has certainly been magnified by the pandemic.

Yet, it is the job of stock markets to be discounting machines as they are still one of the leading indicators of company performance and economic activity. So, are we now getting closer to the time when the reflation and re-opening trade are fully priced into markets?

Last month, we wrote about the continued bullishness of some of the smartest guys in the investing world. About 90 per cent of respondents in a widely watched survey of fund managers expected company profits to grow. That figure is more than in the dot-com boom in the early 2000s and the final quarter of 2009 when the global economy was coming out of the financial crisis.

A heads-up on price pressures and the potential for pass-through will be closely scrutinised

Hussein Sayed

But small changes in the performance of US stock markets, in particular, are worth noting as the world moves into the next stage of its recovery.

Parts of the equity market that were set to benefit hugely from the reopening of economies are now under-performing the broader market. These cyclical leaders, typically technology stocks and smaller companies, have enjoyed their extended period in the sun and were due for a pullback.

Their strong performance duly raises the bar for future returns, while leaving sentiment exposed to more negative developments. Some strategists are highlighting the possible warning sign that comes with a change in stock leadership, cautioning that the actual reopening of the economy may be harder than thought.

This is why the current earnings season will be a focus for many investors. Forward guidance from companies that informs the expected future path of growth will probably be more important than actual results themselves.

A heads-up on price pressures and the potential for pass-through will also be closely scrutinised, in tune with the higher inflation narrative currently being discussed across trading desks. Indeed, one of the challenges now on the horizon is whether corporate profits can exceed current estimates to drive further market gains.

One other external factor to consider is the matter of higher taxes that are coming soon for global companies. Whether that comes in the form of the global minimum corporate tax proposed by the new Biden administration or a domestic levy is a topic for debate.

But rising input costs and taxes to offset the stimulus that governments have released to ease the pandemic will certainly not boost corporate margins.

Hussein Sayed is the chief market strategist at FXTM.