Reflation trade characterises year-to-date returns

The end of March marks the end of the first quarter of 2021, which was characterised by a reflationary period: an uptick in inflation and growth expectations, following last year’s pandemic triggered recessionary environment. Driven by the loose fiscal and monetary policies and the surge in commodity prices, financial markets generated strong quarterly returns since the start of the year.

Both the US and European equity markets gained on a year-to-date basis, with the European markets trading ahead by around 3%. The strengthened optimism in the economic recovery has continued to drive up expectations for growth and inflation, particularly in the US, pushing yields higher and triggering a market rotation into value strategies. As a result, across both regions, the energy and financial sectors were the best performing sectors for the quarter. Meanwhile, defensive plays such as the consumer staples, utilities and healthcare sectors underperformed relative to the broad market index.

In the US, which is benefitting from a stronger improvement in macroeconomic fundamentals, the energy sector surged by 35% over the quarter. The rally across the energy sector was twice as much compared to the European energy sector. In addition, the US industrials and material sector also outperformed, benefitting from accelerated hopes for an economic rebound. On the other hand, US growth sectors such as the technology and consumer discretionary sectors, which performed strongly during 2020, are now trailing behind.

March also reminds us that a year has passed since the market bottomed in 2020, amidst the heightened uncertainty and volatility triggered by the global spread of the covid-19 pandemic. From a yearly perspective, both regions recorded strong double-digit returns across all sectors. Nevertheless, the US equity market outperformed its European counterpart by more than 13%, over the year, and managed to beat European returns across all sectors. The cyclical sectors recorded the strongest one-year gains, led by the energy, materials and information technology sectors, which notched gains between 70% and 85% in one year.

Following the rally in equity markets, absolute equity market valuations stand at historical highs. In this regard, focus now shifts on earnings growth momentum as the key driver for the next phase of the cycle. Analysis of the fourth quarter earnings season underscores the stronger rebound evident across the US compared to Europe, despite that both regions managed to beat market expectations. US listed companies, in aggregate, managed to record positive earnings growth in the fourth quarter, while European companies still notched an earnings decline.

In terms of earnings expectations, bottom up earnings estimates also capture the reflationary hopes that have characterised financial markets in 2021. According to Factset, aggregate earnings estimates for the first quarter in the US, have increase by 5.7% since the beginning of the year. As a result, the estimated earnings growth rate for the S&P 500 in the first quarter increased from 15.8% to 23.3%. All sectors, with exception to energy and industrials, are expected to generate a year-on-year increase in earnings. More importantly, however, the energy and financial sector have recorded the largest increase in estimated earnings growth for the quarter, benefitting from the surge in oil prices and a rise in yields.

Disclaimer:

This article was written by Rachel Meilak, CFA, Equity Analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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