Feature Stories | Dec 17 2020
Despite strong stock market gains form the March low, consensus is that Australia, and the world, will see further gains on robust 2021 earnings growth
-Short term risk ahead of vaccine rollout
-Rotation into value to be ongoing
-20% earnings growth possible
-Not without further risks
By Greg Peel
New Year’s Eve 2020 should see the greatest party since 1999, social distancing notwithstanding. The turn of the millennium was a once in a lifetime occasion, although nervous eyes were turned heaven-ward in case planes began falling out of the sky at the stroke of midnight.
This year’s party will be all about waving goodbye, and good riddance, to the Year of Covid. But while it may be cause for celebration in Australia, and New Zealand, it will not be the case in the northern hemisphere. From the UK to Europe and the US, a Year without Covid is not yet on the horizon.
2020 has been a bit of a turbulent year for investors. We recall that it was in December 2019 that the ASX200 finally regained its losses from the GFC more than a decade earlier. In February this year the index hit a new all-time high. Then came the Black Swan of all Black Swans.
The speed and depth of the covid plunge caught many an investor on the hop. Arguably the correction was too severe, driven by the sheer panic of the unknown that was a global pandemic. This is evident in the fact the sharp rebound beginning in March, driven by unprecedented monetary and fiscal stimulus, also caught investors on the hop.
Nine months later, has the rebound also overshot?
Darkest before the Dawn
November brought the sharpest surge in the rally from March thanks to consecutive “Vaccine Mondays”. First Pfizer and BioNTech, then Moderna, then AstraZeneca and Oxford University announced vaccines that were not only developed faster than anyone thought possible in early 2020 but showed efficacy well above and beyond previous vaccines.
The Pfizer vaccine is already being rolled out in the UK and US, with not only the other two to follow but several more candidates nearing the end of testing. As US-based Lazard Asset Management suggests, such events would typically be the all-clear signal investors need to shift out of defensive work-from-home beneficiaries and into cyclical recovery plays.
However, the resurgence of the virus in the northern hemisphere and subsequent re-lockdowns are increasing the risk many companies, particularly small businesses, might not make it to “the other side”.
This would imply an opposite market reaction to that of the positive vaccine news. Hence investors face a timing conundrum, suggests Lazard, indicating it is always darkest before the dawn.
It is thus fair to say the global outlook for 2021 is “mixed”. The good news is we are at the beginning of the end of the pandemic, but the bad news is the process to get to the end of the end will be long and complex, and life may not return to normal in wealthy developed countries until 2022.
Lazard does not by inference include Australia in this collective of wealthy developed countries, but it remains inevitable that whatever happens overseas, particularly on Wall Street, will impact on the Australian market whether justified or not. Life in Australia has a strong hope of returning to some form of normal in 2021, but the investment outlook remains uncertain.
That uncertainty is exacerbated by the failure of Congress to agree on a second US stimulus package even as the death toll accelerates daily, government support for the unemployed (JobKeeper equivalent) is due to expire on Christmas Eve, and rental eviction bans are set to expire on New Year’s Eve.
Weekly new jobless claims in the US have already turned back up again, and 2021 will potentially open with Americans not only struggling with unemployment, but with homelessness. Many more small businesses will go under in the meantime, at least up until inauguration, but if the Republicans retain the Senate in the Georgia run-offs, stimulus stalemate could well continue for months thereafter.
On the other hand, Europe learned its lesson after the GFC. In the dark years in Europe following the GFC, the wealthy EU members effectively punished the intransigent smaller members by applying austerity rather than stimulus, thus assuring the PIIGS couldn’t fly. The ECB did its best, but the risk was the EU would fall apart at the seams.
This time around, again with the ECB doing its best, the EU is applying massive and coordinated fiscal stimulus in a cooperative effort Helmut Kohl and Charles de Gaulle could only have dreamed of.
Meanwhile, China has rebounded rapidly and is on track to post growth levels in 2021 not seen in years, again on the back of significant monetary and fiscal stimulus.
Australia’s fiscal stimulus is ongoing. While specifically pandemic-related support (such as JobKeeper) is winding down, other measures (such as housing support) have been introduced and the October federal budget was heavy on indirect stimulus (eg infrastructure). One also gets the impression the government will extend measures beyond their current deadlines were the situation to require, with the sort of bipartisan support that is beyond Americans.
Through these countervailing forces, says Lazard, and with equities appearing expensive by historical standards, finding attractive sources of income and diversification is challenging. Navigating the market is treacherous, but global central banks hoping to invigorate growth and increase inflation expectations continue to prop up the value of financial assets.
That said, we appear to be approaching a point at which central banks can no longer drive the economy. This is most evident in Fed chair Jerome Powell’s public frustration in the lack of US stimulus agreement. If this is the case, security selection will be more important than ever, Lazard warns, as we wait for a paradigm-shift to economic growth that gives rise to the next investment regime.
The Upside Case
Given second (or third) waves in Europe and the US, Janus Henderson expects work-from-home and e-commerce solutions to remain in demand over the coming months. The products and services of several sectors have been integral in helping businesses and households navigate an uncertain 2020.
More recently, innovative pharmaceutical and biotechnology companies have come to the fore as the race to a vaccine and other therapies continues. The value these sectors are adding to the (US) economy is reflected in the generation of some of the highest market returns so far this year.
Even more recently, materials have joined in, benefiting from fiscal expansion in China.
On the other hand, travel and energy could remain challenged in the absence of a widely available vaccine, which realistically remains a long way off, Janus notes, and banks face headwinds from perennially low interest rates weighing on margins.
Overall, Janus Henderson is positive on 2021. The highfliers of 2020 will kick on and potentially be joined by other sectors as evidence builds that a V-shaped economic recovery is emerging. Major global purchasing managers’ indices (PMI), which are seen as a robust economic indicator, have returned to expansion territory, albeit off very low bases. Consensus forecasts are that having fallen -3.9% in 2020, the global economy will grow by 5.2% in 2021 and 3.6% in 2022.
Retail sales were quick to rebound in the US in the first half of the year and business spending resumed. Australia experienced a bumpy rebound in retail sales, impacted by Victoria, but expectations are for a bumper Christmas. Business spending is slowly recovering, again off a very low base.
While consumers may again shut their wallets in the event of a major viral breakout – more a risk in the US than in Australia – Janus Henderson notes many countries have coalesced around the idea that certain economic activity remains essential and many companies have learned to adapt their business models to accommodate changes in client behaviour.
The US September corporate earnings season saw 82% of S&P500 companies beat consensus forecasts by an aggregate 17% above expectation. As was the case in the Australian results season in August, forecasts tended to err to the low side given (a) little company guidance was offered and (b) better to be safe than sorry.
S&P500 earnings are expected to decline by -9% in 2020 compared to 2019, notes Janus Henderson, but they are forecast to rise by 22% in 2021 and another 16% in 2022. Leading expected gains are industrials, consumer discretionary and materials – all economic growth-dependent sectors and those hit hard by the earlier lockdowns.
Many companies are in far better positions than Janus Henderson expected a few months ago. Much of the resilience is attributable to lessons learned in the GFC and subsequent slow recovery. Back then companies streamlined processes and repaired balance sheets while industries pursued rationalisation. It appears a similar playbook is being followed now, Janus suggests, but at an accelerated pace and with greater government assistance.
The strongest corporate management teams understand well that the next crisis is potentially just around the corner. Janus Henderson believes risk-aware and resilient companies often come out the other side of a crisis in an even stronger position. One way to achieve this, which Janus notes is receiving little attention, is industry consolidation. The analysts expect companies with room on their balance sheets to seek businesses or business lines that are complimentary to their core offerings and that allow improved cost structures and pricing power.
I would wager it has not been the case of “little attention” in the Australian market. The virus forced many a company to raise capital for the sake of survival, but there has also been a steady flow, more recently, of corporate M&A, and in many cases capital raised for the purpose.
There has also been a notable increase in stock analysts singling out companies as possible takeover targets.
Interestingly, in the low interest rate environment, and share buybacks banned by the Fed for now, US banks are seeking to expand into higher margin businesses, with wealth management an example.
Australian banks, on the other hand, have been ditching their wealth management businesses with gay abandon. This is nevertheless more of a Royal Commission response than a covid response.
That same low interest rate environment has forced investors into riskier assets, in particular equities, in order to generate at least some return. While it is a move up the risk curve, Janus Henderson notes there are implicit trade-offs.
The first and most obvious is the capacity for companies to refinance the debt on their balance sheets at rock-bottom rates, thus reducing their interest cost and increasing profitability. Low rates also reduce the hurdle for capital projects to become profitable.
Less obvious is the mathematical nature of discounted cash flows. Stock valuations are typically based on earnings expectations up to five years into the future. Those earnings forecasts are then discounted back to today’s dollars to provide for a target price. The lower that discount rate, the greater today’s dollars will be, hence the higher the valuation.
This has the effect of pushing up a stock’s near term price/earnings multiple, such that what looks expensive in historical terms is simply not. This is most evident for today’s popular “growth” stocks. Discounting that growth at low rates means many of these trade on eye-catching PEs.
The Value Play
The “value” versus “growth” debate is a hackneyed one, and has particularly lingered in the years since the GFC given the rise and rise of Big Tech. And particularly Little Tech that becomes Big Tech, through accelerated growth. Yet never more has this debate raged than in the Year of Covid.
“Value” typically represents older world industrials in the general (rather than sector-specific) sense, that fall out for favour with investors not because they’ve done anything wrong, but because their plodding earnings growth is not as appealing as that of the “disruptors” and world-changing tech companies. Such plodders are what made Warren Buffet a billionaire.
In 2020, a lot more stocks became “value”, in the sense their share prices plunged. But cheap does not by definition imply value. To be a true value stock in 2020 a company has to be perceived to be only suffering a temporary setback, and will ultimately come out “the other side” as things return to normal.
There were a few attempts at rotation into value and out of growth in 2020, but only when the first vaccine was announced in November did value finally take off. As far as Macquarie is concerned, it is value that will lead the Australian stock market higher in 2021.
On the assumption covid vaccines actually do work, Macquarie is looking forward to “reflation” in 2021. The broker expects economic growth to peak around April when we lap the first shutdowns, and the RBA’s $100bn QE program is completed. Annualised returns will hit 21% in the Recovery & Expansion phase, before dropping back to 11% in a subsequent Slowdown phase. Cyclical stocks typically peak during a slowdown phase, Macquarie notes, thus a shift in leadership back towards defensives is anticipated towards the end of 2021.
The recent run of AGMs and trading updates suggests a strong upgrade cycle is already underway. Consensus implies earnings per share rising 10% in 2021, and Macquarie suggests that’s low. When the economic cycle was at a similar point after the GFC, earnings were 20% higher a year later.
Macquarie believes we could see such an earnings lift this time around as well. Earnings are coming off a very low base, and are supported by fiscal and monetary stimulus. The vaccines are set to unleash a wave of consumer spending, the broker foresees, as high levels of household savings are drawn upon. Throw in strong commodity prices, and 20% growth is not unrealistic. The “covid losers”, such as travel & leisure, could see some of the largest earnings upgrades, Macquarie suggests.
For value, it’s “now or never”. While rotation into value has already been in play since November, Macquarie believes the odds still favour value as it tends to outperform in both expansion and slowdown scenarios (in this case the slowdown being coming off the peak from expansion, not sliding into another recession). The broker notes PE dispersion remains at record high levels.
PE dispersion is the gap between the lowest and highest PE stocks. Stocks trading below their historical average PEs because of covid disruption (but not destruction) represent value while growth stocks trading at high PEs are potentially overvalued, or at least upside is priced in.
The one drag on earnings upside as the economy reflates is a resultant increase in bond yields. Macquarie expects a rise towards 2% next year. As noted above with regard discounted cash flows, growth stocks pricing in expected future earnings are more impacted in valuation terms by higher rates than stocks with lower but more longstanding and reliable cash flows.
A higher discount rate implies a lower market PE, but this does not bother Macquarie as long as forecast earnings upgrades do come through. To mitigate the risk from rising yields, Macquarie favours owning stocks that perform better in periods of reflation, being resources (ex-gold), financials and value in general. Financials is a “key” value sector, the broker notes, given higher rates imply higher margins.
Stocks that will be impacted by higher rates are those that benefit from lower rates, such as gold, bond proxies (eg utilities, REITs, infrastructure funds) and growth in general.
Macquarie expects the commodities up-cycle underway, particularly in iron ore, steel and copper, to continue into 2021, supported by a wave of government infrastructure stimulus. The offset is a subsequently rising Aussie dollar, which Macquarie suggests should already be at US79c based on commodity prices and the interest rate differential to the US. The broker still favours resource stocks, while domestic industrials are preferred over offshore earners.
All Aboard
Macquarie is not Robinson Crusoe. The general consensus is 2021 will be a year of solid post-covid earnings growth in Australia – potentially as much as 20% — implying a continuation of the stock market rally.
Risks are also nevertheless acknowledged, particularly regarding the timing gap from first vaccination to last in the northern hemisphere.
Stockbroker Wilsons would not be surprised to see some near term consolidation given the pace of the recent bounce, a stretched market PE multiple, and the fact everyone has a positive view. The latter can be contrarily dangerous. Wilsons remains “constructive” on a 12-month view.
The broker sees 5-10% capital gains in 2021 as a base case, with risk skewed to the upside given a highly stimulatory fiscal and monetary backdrop. Australia’s enviable management of the virus is beginning to show up in a superior economic performance. The GDP bounce of 3.3% in the September quarter was the strongest in 44 years. Mind you, the -7% drop in June was unprecedented.
Importantly, consumer spending drove the rebound in the September quarter as households began to spend the savings they had built up to that point from (a) being locked down and (b) government handouts. Savings had hit a record 22% in the June quarter but despite this being unleashed, remained at a “still massive”, Wilsons suggests, 19% at the end of the September quarter.
With borders reopening, restrictions easing and everyone home in the country for Christmas, that 19% may diminish in a hurry in the December quarter.
Australia’s GDP was still down -3.8% year on year at end-September and unemployment is at 7% rather than 5%, but Wilsons believes 4-5% real GDP growth in 2021 is plausible. Hence Wilsons, too, sees 20% earnings growth as a possibility. By the second half of the year, vaccinations should mean the northern hemisphere can begin to catch up.
Hence Wilsons sees the prospect for 5% global GDP growth in 2021, following -4% in 2020. This should translate into a 20%-plus global earnings recovery in 2021 which will extend into 2022.
It should nevertheless be acknowledged the ASX200 is already up over 40% from its March low, and a 20x market PE is historically high. But market estimates will likely prove too low, Wilsons believes, for cyclically leveraged sectors such as the banks and energy, alongside a long tail of specific individual, virus-hit stocks set for recovery. Indeed, 60% of the ASX100 is set to benefit from a two year recovery by varying degrees, the broker suggests.
So back to that 20% earnings growth prospect for 2021, and further double-digit gains in 2022. One-year forward earnings estimates are still some -16% below pre-covid levels, so despite the 40% index gain to date, there is plenty of upside for 2021-22, Wilsons declares.
What’s more, the broker believes stocks could still be considered cheap on a standalone basis of effectively zero interest rates. Typically, the market PE comes down as earnings grow, but given ultra-low rates and ample liquidity, Wilsons believes this time the multiple could hold for a while.
Bond yields are expected to begin rising, led by the US, but with central banks committed to zero rates for a long time yet it is unlikely they will upset market valuations. At least not until later in 2021 when, it is assumed, the world will be vaccinated.
Drilling down into sectors, Morgans believes the stock market rally from the March low has disproportionately rewarded the stay-at-home plays. The subsequent rotation into cyclicals/value in November was sharp, but the valuation discount of these stocks was so large Morgans suggests the comeback is not over yet.
Morgans believes the rotation can continue for another year or two. To that end the broker expects the technology and communication services sectors to underperform, while strong gains should be seen in financials, energy and industrials, which have been hardest hit by covid.
The Risks
Let’s start with a risk that has not been much discussed. While the three vaccines to date have shown over 90% efficacy in trials, it is as yet an unknown whether they are permanently effective, or wear off over time. This can only be confirmed over time.
A risk that has been much discussed is that of general public reluctance to be vaccinated. Polls in the US suggest only around 50% of respondents say they will indeed be vaccinated, meaning 50% won’t. Not because they’re staunch anti-vaxxers, but because they are wary of the unprecedented speed with which these vaccines have been rushed into distribution.
Many would rather wait for a while to gauge how the vaccines fare, which suggests it may take longer than the assumed few months for “the world” to be vaccinated. Ultimately not everyone in “the world” will choose vaccination anyway, unless perhaps they fall ill. This implies covid may never actually go away.
The recent discovery of a new strain of covid in the virus-ravaged UK is also worrisome. Perhaps we will need to be vaccinated every year, like the flu, as the virus mutates.
Notwithstanding all of the above, as was highlighted at the beginning of this article we still have to get to the point at which “the world” is vaccinated, and that means getting through a northern hemisphere winter in which covid is running out of control. The UK, France and Germany are now returning to various degrees of a “hard” lockdown for Christmas. Areas of the US, such as California and New York City, are following suit.
That translates to another round of economic impact, and perhaps an ongoing recession for some time yet.
It’s currently a fluid situation, but the risk remains US Congress will not be able to agree on a stimulus package.
The jury is out on whether inflation may present as a risk. Central banks are committed to zero rates and other monetary measures for as long as it it takes, and the Fed, of one, is prepared to let inflation run a bit higher than target before it feels the need to respond, which would be to raise rates, or at least wind down QE and other measures.
With the “massive”, as is the popular adjective, amount of fiscal stimulus being thrown at the global economy, the risk is prices do indeed start to rise. But on the other hand, the RBA has highlighted the extent of spare capacity in the labour market (number of unemployed) as a buffer against wage inflation, and price inflation typically requires wage inflation to kick off an upward spiral.
Clearly Australia is not alone on the spare capacity in the labour market front.
Coming back to that massive fiscal stimulus, another risk – and this is particularly true for Australia given we seem to have all but conquered covid – is that the government, desperate to reduce its budget deficit, pulls its support packages too early, risking another tip-over of the economy.
Finally, as has already been alluded to, the risk is that if everyone runs to the same side of the ferry, with regard their market expectations, the ferry is in danger of tipping over.
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