International | Sep 23 2020
If world stock markets are in the early stages of a new equity cycle, where should investors look to maximise returns?
-The prospects for financials and small cap stocks
-The outlook for emerging markets
-Inflation versus globalisation
By Mark Woodruff
Opinions vary widely on the future direction for world stock markets. Fiscal and monetary support provided so far has been unparalleled. Globally, quantitative easing by central banks in 2021 is expected to more than double the previous peak in 2010, in the wake of the global financial crisis (GFC).
As a result, many macroeconomic indicators are pointing toward a recovery. The question remains, what sort of recovery – goldilocks, V-shaped or short-lived?
As always, there are no shortage of looming troubles on the horizon. Some common concerns include the virus, trade wars and a victory for the Democrats in the US elections. The latter would likely see a major switch in policy direction and a different regulatory and tax regime.
So it is timely to review the way forward for investors.
Views on a recovery
Portfolio managers at T Rowe Price believe we are in the early stages of a new equity cycle. The American global investment management firm has attempted to calculate the time period for the world to recover to the pre-pandemic starting point. Valuations when the virus first struck in 2020 were seen as reasonable. As a result of the recession triggered, it is considered the world may lose around 18 months of GDP. If markets rise by a moderate 5-7% over the next 12 months, then essentially, we are going to end up with a market and GDP at broadly similar levels to pre-covid.
The macroeconomic data points Morningstar toward a view of gradual recovery, despite elevated levels of new virus cases. This provides a useful reminder of the resilience of the major world economies. Nonetheless, higher infection rates may return. The recovery may be slowed by weak confidence and limited investment, combined with continued weak demand in entertainment, travel and hospitality industries.
There is some confidence for a deep V-shaped recovery, with Morgan Stanley expecting a return to pre-covid levels of output, with the global market economy recovering by early in the fourth quarter 2020. The economy in developing markets is expected to recover by the third quarter 2021, while the second quarter of 2021 is considered likely for the US.
The broker expects an additional US$1.5-US$2.0 trillion CARES 2 package (economic assistance for workers, families and business) will be passed, despite the current stalemate. The passing of the US fiscal package would mean a faster US recovery. However, on the flipside, failure could mean major disappointment.
According to strategists at French powerhouse Amundi, the uptrend appears uncertain as current levels seem to fully price-in an economic recovery, and to some extent an available vaccine. On the other hand, the asset management company believes the bottom has passed, but economies do not seem to be climbing out of it quickly enough to ensure a fast healing. However, this still translates into pre-covid levels being reached several quarters from now. This is with the exception of China, which is considered likely to reach an end-of-2019 growth level by the end of 2020.
Stockbroker Wilsons ultimately envisages a sweet spot of good growth and moderate inflation that should support equities and other risk assets. This phase could run for several years.
However, this goldilocks phase is unlikely to last forever. Inflation and bond yields are likely to move up eventually. This may not be high inflation in the historical sense, but it may be significantly more than is currently priced, notes the broker.
Views on Inflation
The recent shift by the US Federal Reserve to its framework for conducting monetary policy has led many economists to reflect upon whether inflation may rise like a phoenix from the ashes.
To achieve its mandate of “promoting maximum employment and stable prices”, The Fed will now be targeting an inflation rate of 2% on average over time, permitting periods of overshooting 2% to make up for previous undershoots.
To get to the above-trend inflation stage (i.e. inflation getting above central banks’ target range), Wilsons think we will have to negotiate a disinflationary period as the covid shock weighs on demand, before giving way to a reflation (Goldilocks) phase as the economy recovers.
With so much policy stimulus in train and a more pro-growth attitude from policymakers, the broker thinks there is a reasonable case that inflation will ultimately overshoot the Fed’s target in this cycle.
The structural forces that have been keeping a lid on the growth and inflation environment are considered to include globalisation, an ageing population and high debt levels. Inflation has also been held down by a highly competitive and increasingly disrupted business environment, with the internet a key enabler of intense price competition. These low inflation drivers are unlikely to disappear, though one of the important disinflationary influences in the last few decades, globalisation, has likely passed its peak, according to Wilsons. (Refer to a discussion on globalisation at the end of this article).
What sectors to Invest in?
Early in an equity cycle it’s often the financials and materials stocks that are unloved, but which later do well in the upswing, advises T Rowe Price. Apart from these adjustments, this is not the time to play outright defence in your portfolio. As mentioned previously, the American asset manager believes we are in the early stages of a new equity cycle.
Sovereign bond yields have been compressed to ultra-low levels throughout the developed world countries and are now also falling sharply in emerging markets (EM). The dividend discount model suggests to T Rowe Price that in a world where the risk-free rate is expected to be much lower, there is a respectable argument that equity valuations can be meaningfully higher, other things being equal.
Another vote for an investment in the financial sector comes from the Morgan Stanley US equity strategists. They view financials as a high-quality cyclical sector that should offer relative upside as an early-cycle outperformer. Coming out of a recession, the broker thinks it pays to buy stocks with the lowest expectations. Financials continue to trade at depressed multiples on a relative basis and are currently at levels even cheaper than during the GFC. Additionally, the broker’s higher forecasts for treasury yields should benefit banks in particular. This is because banks exhibit a strong positive correlation to yields.
Equity strategists at Morgan Stanley are also forecasting small-cap earnings will recover more quickly than large-cap earnings, and relative price performance has yet to reflect this. As the recovery progresses, labour costs tend to be slower to accelerate. This mismatch in growth rates benefits margins, especially for companies where labour costs tend to take a higher percentage of revenue.
According to analysts at T Rowe Price, it makes sense to divide EM into four different buckets. In one of those buckets resides a superior investment that contains a small number of EM countries with a number of key characteristics in common. They are each demographically blessed with low levels of debt-to-GDP, “normal” interest rates and meaningfully higher structural growth rates. Examples include India, Indonesia, Philippines, Vietnam and Peru.
To the extent that covid is leading to a lower-interest-rate world for longer and also a lower-growth world for longer, then being able to invest in these fast-growing EM countries will be more important than ever, highlights T Rowe Price. Many successful multi-national companies appear to be increasing their focus on these EM countries, with a view to building up their operations there.
Amundi’s regional preference remains for China, Indonesia, South Korea and Taiwan, not least because of the strong stimulus and sector-mix exposure. Additionally, selected emerging markets have demonstrated a better containment of the contagion.
Geopolitical issues such as US-China relations and the pandemic are the key factors affecting emerging markets at the moment and Amundi favours countries in the Asian region (South Korea, China) in light of a first-in, first-out approach to the virus.
The asset manager has a watching brief for EM inflation. It started to pick up in July, mainly driven by supply shocks. Goods and food, in particular, are still playing an important role in CPI baskets. However, the overall picture is expected to remain benign, bringing headline inflation within central banks’ targets. Nonetheless, the price dynamics are worth monitoring given the huge dovish efforts put in place by most of the central banks.
Other Regional recommendations
Equity strategists at Morgan Stanley prefer European assets versus other regions. The investment case for European equities should also benefit from higher and more stable trend EPS growth, as the region's stock market transitions to a superior sector mix. MSCI Europe’s ‘old economy’ label is no longer true, according to the broker. Healthcare, staples and industrials now comprise 45% of the index, while banks and energy make up just 10%.
Entering 2020, the increased geopolitical tensions and emergence of a multipolar world have led to a growing need for China to fast-track renminbi internationalisation, so as to secure capital and reduce funding risk. As a result, Morgan Stanley expects reforms to accelerate in a number of areas, including a further opening-up of the financial market and continued domestic reforms to boost productivity.
In the eyes of the broker, the China A-share market remains attractively priced, with the CSI300 trading at a -4.5% discount versus MSCI China on a 12-month forward price earnings basis. The A-share market tends to be more resilient in the face of US/China geopolitical uncertainty.
Amundi states that some countries in Europe, the Middle East and Africa (EMEA) region have attractive valuations. The asset manager also likes those with good dividend yield prospects such as Russia and Poland.
In Europe, construction materials are a fertile hunting ground as there are high barriers to entry and it is a key beneficiary of the Recovery Fund (A package to help the EU rebuild after the pandemic and will support investment in the green and digital transitions). Conversely, despite good growth, technology (software in particular) is not immune from the effects of covid. Current valuations are extreme, suggesting that caution is warranted in this space, warns the asset manager.
The economic environment is improving but the risks of a second wave of the virus have emerged that could affect a staggered recovery. The second quarter earnings season surpassed expectations which were already depressed, with very low forward visibility. As a result, valuation dispersions remain high. Looking ahead, investors should stay very selective and aim to identify resilient business models, suggests Amundi.
The European asset manager expects US equities will continue to offer better value than bonds. However, the momentum and valuation divergence between mega caps and large caps versus the rest of the market is extreme. This is despite the uncertainty around US elections and a resurgence of virus cases in some states. In this environment, it is important to remain balanced, according to the French company. A leadership rotation is considered likely, and investors should look to high quality value names.
In general, commodities are still the cheapest risky asset class, and may well benefit more than others from an economic recovery, Amundi suggests. Economic recovery is considered to favour commodities, although uncertainties prevail over the evolution of the pandemic and possible lockdowns. However, recent macro numbers in China and the US remain supportive.
Oil demand is expected to recover after collapsing by -11 million barrels per day in the first half of 2020. Amundi forecasts an oil price of US$35-45/bbl for WTI crude. Morgan Stanley is also expecting higher prices next year.
In metals, the recent sell-off in gold and silver is related to the concerns of higher real rates, “normal” risk-on and the Federal Reserve pause of asset purchases. However, Amundi expects central banks will remain extra dovish, preventing any painful sell-off going forward. Morgan Stanley concurs as gold retains its status for the broker as a real yield proxy. This means, historically, there has been an inverse relationship between real interest rates and gold.
Morgan Stanley points out that corporate credit is seeing better total and excess returns than on average, especially within high yield.
Similarly, in a world of lower-for-long rates, strategists at Amundi believe credit is one of the few areas where investors can find yield.
Debt spreads have continued to narrow, but are still far off their pre-covid levels. The discrepancy is particularly large between high yield and investment grade. The latter is viewed as increasingly expensive, while in high yield there is ample room for compression from current levels.
Additionally, a strong housing market and a resilient, deleveraged consumer, have combined for attractive valuations in the consumer and residential mortgage credit markets, according to strategists at Morgan Stanley.
Why are current opinions on the rate of globalisation worthy of investigation?
Globalisation is one of several factors that have suppressed growth and hence bond yields for an extended period. A reversal of globalisation, all else being equal, could potentially lead to higher bond yields, making equities relatively less attractive.
After rising rapidly in the 1990s and 2000s, the ratio of trade over global GDP in real terms has risen much more slowly in recent years, before slumping this year because of the pandemic.
Since the GFC, changes in economic and political dynamics have impeded economic globalisation, although less so than the headline numbers suggest, according to Oxford Economics. Some observers have concluded globalisation has already gone into reverse, with international trade having fallen as a ratio of global GDP since the GFC. However, the leader in global forecasting doesn’t expect globalisation to go into reverse, but thinks it will continue to proceed at a significantly slower pace than in the heyday of 1990-2010.
The deceleration in globalisation has in part been a natural economic outcome, says Oxford Economics. An outcome reflecting a number factors including rapid growth in some Asian EM economies, i.e. domestic demand has outgrown demand for exports. Also, some Asian EM economies have moved up the value chain and expanded their domestic supply chains. This has reduced their reliance on imported intermediate inputs.
Additionally, shifts of production closer to markets and labour-saving technological progress have contributed. But it also reflects policies that erect barriers to trade and investment, such as tariffs in the US-China trade war.
In short, actual de-globalisation is not expected. Additionally, Oxford Economics forecast significant catch-up and economic growth in EM in the coming decade, especially those doing relatively well in Asia and Eastern Europe.
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