Equity investors, quite rightly, remain resolutely focused on the positive, medium-term outlook for corporate profits rather than the near-term economic challenges. In our view, the economic recovery and rebound in inflation will drive a rotation into value and small-cap stocks. As result, value should recover some of its underperformance of recent years. Nonetheless, we expect quality/growth to retain its dominance in the future.
Equity investors began 2021 focused on the expected level of earnings at the end of the year rather than on the inevitably rocky path to reach them. With economies globally in a synchronised recovery, higher earnings are almost assured; the worry is rather whether the currently expected level turns out to be too optimistic and whether the market multiple placed on those earnings is unsustainably high.
While most markets ultimately posted gains in 2020, we expect the order of the winners in 2021 to be different. Instead of growth, technology and internet-leveraged sectors, we see small caps and value as the leaders.
Similar to 2020, the US should outpace Europe. We believe the rotation from growth into value will continue as inflation expectations and bond yields rise modestly, but we do not see it reversing the multi-year underperformance of value or change the positive, medium-term outlook for quality growth stocks.
One thing that has perplexed many investors is the seeming disconnect between the biggest decline in gross domestic product since World War II and equity markets gains of 18% for the year. It is exactly the focus on GDP rather than household income, however, which has created the confusion.
The institutional response to the recession has been dramatically different from the past, in part because the COVID-19 recessions were caused by government-imposed lockdowns as opposed to an external shock. The loss in US household income was replaced by government support and personal income rose rather than fell over the course of the year. (In Europe, household income is always more resilient thanks to existing welfare support programmes.)
Government fiscal support amounted to as much as 12% of GDP and the US is on track to add perhaps another 6% in 2021. This helps explain why corporate revenues fell by far less than GDP.
Thanks to central banks, companies were able to raise even more cash than during the global financial crisis (GFC) and at very low interest rates to tide them over through the slowdown in activity.
Consequently, corporate profits are expected to recover more quickly than they did after the GFC, rebounding in the US by a forecast 22% and by 35% in Europe. This will nonetheless only be marginally higher than pre-pandemic earnings for US companies and is actually still down by 11% for Europe, suggesting that market expectations are not wildly optimistic (see exhibit 1).
Waiting for an upturn in value stocks has required significant patience over the years, although, arguably, the style held up well during the post-GFC recovery through to Donald Trump’s election as US president. The tax cuts by his administration particularly benefited tech companies, which have a significant weight in the growth indices. The boost to internet-leveraged companies during the lockdowns further accelerated the trend of value underperforming growth (see exhibit 2).
Nonetheless, there have been periods of value index outperformance since the GFC, notably 2012-2013 and in 2016. The question facing investors today is how long the current rally can last; we expect that it will be at least as brief as those over the last decade.
It is not accidental that the previous value recoveries coincided with a sell-off in US Treasuries and a rebound in oil prices. The financial sector has by far the largest weight in the value indices, and volatility in energy prices leads to an outsized contribution to value’s performance when commodity prices are rising. That dynamic of rising bond yields and commodity prices exists today and we expect it to persist for a while.
In this environment, we see scope for a further, partial normalisation of relative valuations. Once valuations have moderated, however, the combination of persistently low yields, a return to trend-rate GDP growth, and the ability of the technology sector to continue to take advantage of economic disruption to drive earnings growth means the longer-term outperformance of quality growth stocks can be expected to resume.
Despite the high valuations of some US technology stocks, we expect US large caps to outperform their European counterparts. The key driver is the divergence that is opening up between the two regions on both the pandemic front as well as the response by governments and central banks.
Few countries have escaped the worse-than-expected winter waves of the coronavirus. While the US has had more infections and deaths than countries in Europe due to its larger size, on a per capita basis, both regions have had similar outcomes.
The government response, however, has been significantly different. While most European countries have deepened and extended their lockdowns, restrictions in the US have remained broadly low. There are few cities or states with stay-at-home orders and most businesses are open. Consequently, US purchasing managers indices have been high and are rising. In many parts of Europe, the PMIs have been in contraction territory below 50 and are falling. Retail sales have similarly been more robust in the US.
Even as Europe locks down more stringently and for longer, the region has less capacity to offset the economic impact. The US is looking at a third fiscal support package, while the EU has yet to distribute the funds from its initial package from last spring. In any case, this money is to be focused on improving infrastructure and climate resiliency rather than supporting demand.
The ECB meanwhile seems disinclined to increase its monetary support (perhaps with reason given how low interest rates already are), while the US Federal Reserve has options left such as reorienting its bond purchases towards the long end of the curve to suppress interest rates if needed.
Despite the strong returns for equity markets in 2020, the recovery from the coronavirus lockdowns is not over. Further fiscal stimulus, low real yields, and an eventual return of economic activity to pre-pandemic levels promise more upside for equities.
Any market setbacks on vaccine delays or spreading virus mutations should be seen as opportunities to increase allocations to those markets and sectors benefiting from reflation: value, cyclicals, small caps, and US and emerging market equities.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
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