CA-EN Advisors

September Monthly MAST Commentary: Strong Earnings Allow Global Equities to Defy Gravity

We remain confident about the resilience of the economic outlook over the next 12 to 18 months as policy support remains extraordinary.
September 2021
  • The Delta variant continues to make progress and delays the return to normal. Emerging economies remain more exposed to the virus than developed economies, but we think central banks will be more sensitive to pandemic risks than equities, unless broad lockdowns are re-instated, which is unlikely, in our view.
  • Global economic and earnings momentum have peaked, but we expect the pace to remain well above trend. U.S. politics could inject some market volatility in coming weeks as negotiations over the budget and debt ceiling continue, but we expect the volatility to be short lived.
  • Policy headwinds, a resurgence of COVID-19, and further cooling of economic growth continued in China. While Chinese stocks have cheapened, ongoing policies against China’s tech sector will likely force investors to demand a higher risk premium on Chinese equities.
  • We remain overweight equities versus fixed-income as we transition to the mid-cycle phase of the cycle. We expect policy support to diminish, but that’s mostly a reflection of the healing economic backdrop.

“We're recovering, but to a different economy”

Fed Chair Jay Powell, November 12, 2020

Strong Earnings Allow Global Equities to Defy Gravity

Global equities registered their seventh consecutive monthly gain, a first since the exceptional year of 2017 when the S&P 500 index climbed every month. While the equity rally of the past 12 months has been stronger than anyone expected, it’s hard to build a negative medium-term (6-12 months) thesis against equities given the exceptional policy support and our expectations for well above trend economic growth over the next 12 months. More importantly, the ongoing equity rally is fueled by strong earnings as the price-to-earnings (P/E) ratio has contracted slightly this year, meaning that equities have cheapened year-to-date although prices jumped 20%. As we head into year-end, market volatility could rise around the negotiations over the U.S. budget and the lingering concerns around the Delta waves, but we think equity pullbacks from potential bouts of volatility from these factors should be seen as opportunities to deploy dry powder into equities.

Global Markets: Equities plowing through Delta fear as interest rates stay low

The tailwind of a strong earnings season pushed global equities (MSCI ACWI, +2.5%) to new highs in August, despite a surge in COVID-19 cases in many countries. Most regions performed close to global equities except for China (MSCI China, 0.0%, down 13% for the year into August), which continues to face a negative regulatory environment and a cooling economy. Emerging Markets (EM) (MSCI EM, +2.2%) stabilized in the last week of the month after suffering steep losses. The U.S. tech stocks (Nasdaq 100, +4.6%) outperformed on growth normalization, Delta concerns, and market expectations that long-term interest rates will remain low for the foreseeable future. The S&P 500 (+3.0%) benefited from its tech sector while small caps (Russell 2000, +2.2%) lagged on cooling growth expectations. European shares (Eurostoxx, +2.6%) benefited from the global rally while Japanese shares (Nikkei 225, +3.0%) were stronger after significant losses in July as the country struggled with COVID-19. Finally, Canadian (S&P TSX, +1.6%) lagged their global peers last month as the energy and mining sectors fell.


With a U.S. Federal Reserve (Fed) that remains dedicated to support the labour market recovery and continues to emphasize inflation is largely transitory, long-term interest rates have remained well-anchored in recent months even as the Fed is likely to reduce its pace of asset purchasing this year. The yield on Canada’s 10yr bond was little changed last month (1.22% from 1.20% in July). The resurgence of COVID-19 cases weighed on Western Texas Intermediate (WTI) oil prices, which fell to $68.50/bbl (from $74/bbl). The recent decision of Organization of the Petroleum Exporting Countries (OPEC) countries to stick with higher production plans into next year despite the resurgence of the virus also weighed on oil prices. The U.S. dollar was little changed (+0.50%) in August, but the loonie retreated (-1.1%) on weaker oil prices and a disappointing second quarter Gross Domestic Product (GDP) growth. Finally, the VIX volatility index (at 16.5%) fell a couple points last month and continues to reflect state non-complacency vis-à-vis the S&P 500 while remaining at levels that suggest investor’s fear is contained.

Global Equity Factors: Mid-cycle transition keeps equity factors in tight range

Global momentum stocks (+3.4%), which currently hold nearly 20% of bank stocks, was the strongest factor in August, closely followed by Growth (+3.2%) and Quality (+3.0%) equities. High-Dividend (+1.1%), Low-Volatility (+1.8%) and Value (+1.8%) lagged their global peers (MSCI ACWI, +2.5%) as the cooling of economic growth and fear over the pandemic weighed on equity factors that struggled prior to the pandemic during the “lower-for-longer” interest-rate regime.

Speed Bump on the Growth Outlook: Cooling, but above trend pace

The Canadian economy, measured by real GDP, unexpectedly contracted in second quarter as the country battled against the pandemic. Households and housing-related spending also took a breather after three strong quarters of growth while supply-chain disruptions also negatively impacted the economy, most notably the auto manufacturing industry. Although the pandemic and the stop-and-go lockdowns are generating an unusual amount of noise in macroeconomic data, this surprising loss of growth momentum will probably cast a shadow over the Bank of Canada’s optimistic economic outlook into 2022.

Not only is the strength of the Delta wave more severe than expected in terms of cases, the world’s two biggest economies, U.S. and China, are undergoing forecast downgrades as economic activity normalizes. Because the recent pace of economic growth in the U.S. was unsustainable, hovering near 6% quarter-on-quarter, we don’t think investors should fear these forecast downgrades.

For equities, the earnings outlook is more nuanced since most firms have well adapted to the pandemic, especially those more digitally oriented. Compared to pre-COVID highs, the U.S. labour market is still down by over 5 million jobs, real GDP is marginally higher, whereas S&P 500 earnings have risen by 15% (Chart 1). Even though firms must offer higher wages to attract and retain workers, their top and bottom lines have improved while the labour-market recovery lags. We expect this dynamic to remain favourable for earnings growth into 2022 although we expect earnings momentum to decelerate along with the pace of economic growth.

Chart 1: U.S. Payrolls Lagging the S&P 500 Earnings Recovery

Chart showing U.S. payrolls lagging the S&P 500 earnings recovery

The chart shows historical monthly data for U.S. non-farm Payrolls, which have fallen sharply during the COVID-19 lockdowns and have only partially recovered; that compares to S&P 500 earnings per share that are now well above their pre-COVID levels. Source: Bloomberg, BMO Global Asset Management. Monthly data, as of December 2020.

China Outlook: Goals of “social fairness” and “common prosperity” remain headwinds for tech

After a few months of targeted interventions against high-profile Chinese tech companies, President Xi’s recent speech argued for continued policy efforts to address increasing wealth and social inequalities, (Source: CNN). The lingering of the virus across EM countries, coupled with a negative policy agenda and cooling economic growth in China, motivated our underweight of EM equities last April. While economic growth could be bottoming, we think policy headwinds could persist and weigh on both the earnings outlook and valuation as investors re-assess the risk premium to Chinese stocks, which can be subject to arbitrary negative government interventions. China’s Zero-COVID policy could prove challenging to maintain if new waves of variants enter the country in coming months. Finally, the financial troubles of property giant, Evergrande, is weighing on Chinese real-estate developers as the company’s debt is on the verge of default (Source: Financial Times).

Fed Outlook: Low bar to taper, high bar to hike

Fed Chair Powell’s Jackson Hole speech sent bond yields and the U.S. dollar lower as Powell outlined several reasons why high inflation will be transitory. While he reaffirmed that the Fed is on track to taper this year, he emphasized that tapering has no bearing on future rate hike decisions. Given that the Fed has been discussing taper for months, and taper itself is not an outright tightening of financial conditions, it’s unlikely to be a key driver of bond yields going forward and therefore not a threat to equities–unlike economic activity, corporate earnings, or rate hikes.

With a low bar to taper but a high bar to hike interest rates, can bond yields recover? On one hand, the Fed’s dovish messaging on rate liftoff, which is unlikely until late 2022 at the earliest, is likely to persist thanks to COVID uncertainty and the Fed’s inclusive labour market mandate. On the other hand, rapid improvement in job growth and sustained supply chain disruptions could lean the Fed more in the hawkish direction. Structurally, long-term bond yields may struggle to recover if the Fed’s terminal interest rate, as measured by 5y5y Overnight Index Swaps (OIS), remains low (Chart 2). One reason markets are pricing in a lower terminal rate of 1.5% is peak growth, higher debt levels and falling stimulus, which suggest that the terminal rate may not rise much above the previous hiking cycle (effectively 1.75%). We think risks are skewed for interest rates to stay within their 2021 ranges while the curve will struggle to steepen more as the Fed’s hiking cycle nears, which should still keep equities supported.  

Chart 2: Long-term Downtrend in the Fed’s Terminal Rate

Chart showing the long-term downtrend in the Federal Reserve's terminal rate

The chart shows the historical level of interest rates implied 5-year rates on 5-year bonds (5y5y), which has been on a secular downward trend since the Great Financial Crisis of 2008-09. Source: Bloomberg. As measured by 5y5y OIS. Daily data, as of 19 January, 2021.

U.S. Fiscal Fireworks: What’s in store for September

In August, the House passed a budget resolution for $3.5 trillion in spending and advanced the $1 trillion bipartisan infrastructure bill, allowing for the next stimulus package to be passed by simple majority. The next month will be packed with headline risks, as Congress aims to pass trillions of spending by October 1 as well as pass a government budget, which expires September 30, and raise the debt ceiling. The latter two requires 60 votes in the Senate. We will learn further details for the $3.5 trillion spending bill, which will likely be backloaded and spread over 10 years, and how it will be funded, likely by $1 trillion in tax increases. This suggests that even if Congress manages to pass further stimulus, it is unlikely to offset fiscal drag next year. An increase in the corporate income tax rate to 25% is expected to shave off about 5% from S&P 500 Earnings per Share (EPS). Depending on when the tax increases take effect, the upcoming stimulus packages are not a game changer for the 2022 outlook, though tax increases are also not currently fully priced in according to betting odds (Chart 3).

Chart 3: Betting Odds for U.S. Corporate Income Tax Rate in 2022

Chart showing the betting odds for a U.S. corporate income tax rate in 2022

The chart shows the betting odds from U.S. betting markets regarding the future of corporate taxes, either below 25% or above 25%, which remain in a tight race. Source: PredictIt. Daily data as of 1 August, 2021.

Outlook and Positioning: Equities remain immune against breakthrough COVID-19 infections

Our portfolio positioning was largely unchanged last month as we remain optimistic about equities, especially versus Federal bonds. While we expect a rise in market volatility in coming weeks, mainly because of U.S. politics, we remain confident about the resilience of the economic outlook over the next 12 to 18 months as policy support remains extraordinary. We continue to closely monitor the evolution of the virus, but we would expect monetary policy to be more sensitive to rising infections than equities, unless broad lockdowns are reinstated, but we think it’s unlikely, notably in the U.S.


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