Multi-asset allocation views: Equities on a style merry-go-round

Although economic growth, operating leverage and valuations support equities, it is too early to tell whether value stocks are finally set to make a comeback, says Sunil Krishnan.

Multi-asset allocation views: Equities on a style merry-go-round

In November 2020, as positive news was breaking on vaccine efficacy, equity markets were slow to grasp the significant prospect of reopening economies. They have since caught up, but continue to underestimate the global economic growth potential for 2021 and 2022.1

For example, the US Federal Reserve (Fed) raised its US growth forecast for 2021 from 4.2 per cent in December – when our estimates were already above six per cent – to 6.5 per cent in March. This is a significant change for a central bank.2 Published sell-side consensus has risen accordingly, yet risks remain tilted to the upside.

Figure 1: Bloomberg economist consensus for 2021 US real GDP growth (year-on-year, per cent)
Bloomberg economist consensus for 2021 US real GDP
Source: Bloomberg, as of April 9, 2021

Markets remain too pessimistic on growth

Two key areas might drive upside risks, in the US and China respectively. First, while the size of US fiscal stimulus is broadly understood and discounted, it is more difficult to assess the willingness to spend of individuals and companies. The private sector has built up large savings over the past year and could release a meaningful amount as the US economy reopens. Market forecasts do not yet fully account for this, most assessments conservatively discounting pre-pandemic levels of spending and not much more.3

Added to this is an idea we have discussed previously, which is the Fed’s willingness to allow the economy to run hot for longer. Instead of acting after one or two months of above-target inflation, it could be several quarters or maybe a year before the Fed considers tightening policy. This is something investors have still not entirely embraced, which adds to the upside risk.4

The second area is that, at the start of 2021, the Chinese authorities spoke publicly about a possible targeted reduction of stimulus in frothy areas, such as the property market.5 However, the appetite for weakening growth in China is questionable, and the authorities have extended support rather than reining it in. That is a positive surprise. Investors generally expected China to face a more material slowdown by now as stimulus wound down, but that does not seem to be the case.6

Small changes have a big impact

The most important factor in translating changes in revenue to changes in profit is operating leverage. While some companies have warned markets of rising input costs, this is confined to those using a lot of raw materials, such as consumer staples. Overall, this is a small headwind, easily outweighed by the large pool of unused capacity that will allow businesses to increase output quickly without significant additional cost. Small changes in revenue can therefore lead to big changes in profits.

Sales growth was 10.9 per cent while earnings growth was 48.6 per cent

The impact of operating leverage has come through in companies’ most recent earnings reports. As of May 5, 2021, 375 companies in the S&P 500 have reported. On average, sales growth was 10.9 per cent while earnings growth was 48.6 per cent.

These figures were a positive surprise when set against analysts’ consensus. The sales growth numbers were 3.7 per cent ahead of consensus, while earnings were 23.4 per cent higher. Operating leverage is not just working to deliver growth, it is also delivering outperformance against expectations.

Against this backdrop, US equities earned solid returns, with the S&P 500 rising over five per cent in April.7

Looking at a couple of sectors, the earnings surprise in industrials was roughly in line with the S&P 500 average, with a positive price performance of 2.4 per cent in the five days following announcements. The consensus for industrials had been much more negative than for the overall index, which supported the larger price movement.

Investors appeared to bank the strong fundamental performance

In contrast, although earnings were 18.9 per cent ahead of consensus for information technology companies, share prices went down by 2.5 per cent in the five days following their earnings reports. Investors appeared to bank the strong fundamental performance, perhaps reflecting high expectations and background concerns about how reflation may challenge high valuations in technology.8

Valuations are not yet extreme

Although broad equity valuations and investor sentiment are high, based on the measures we consider, they are not yet in extreme territory. For instance, market volatility has declined, but not to a point which would suggest widespread complacency. As of May 5, 2021, the VIX index of implied volatility stood at 18.7; this is much lower than January, when it peaked at 37 as markets corrected, but is not particularly aggressive by historical levels. By comparison, before markets became more volatile in 2018, the VIX hovered around ten for most of 2017.

Figure 2: VIX index, 2017 – 2021
VIX index, May 2017 – May 2021
Source: Bloomberg, as of April 9, 2021

Stronger economic growth than expected, alongside operating leverage, is translating into healthy company earnings and being rewarded by investors.

Dramatic style rotations

It has been a dramatic year so far for style rotation. We have at times seen strong performance from some value companies, including some of the biggest losers from the early period of the pandemic that have started to recover at the expense of growth stocks.

This has spurred a widespread debate on whether the rotation from growth to value is a long-term trend. It is still too early to tell; for value to really gain traction, we need to enter a period of more meaningful reflation.

Headline inflation numbers are going to rise in the next few months

Headline inflation numbers are going to rise in the next few months, but it is not clear whether it can be sustained in a way that will restore pricing power to value sectors, such as certain commodities or heavy industry and manufacturing.

Financials are another important value category, but it remains to be seen whether reflation will translate into even higher rates and a steeper yield curve that would further restore banks’ profitability.

We are still agnostic on the outcome; our base case is that inflation is likely to moderate after the initial rebound, hovering closer to central bank targets or just above them; this may not be quite enough to continue the pace of gains we have seen in value stocks so far in 2021. It is worth recalling how consistent the performance of growth stocks has been over the last 15 years. However, things could prove different this time. The combination of accommodative monetary policy and generous fiscal policies could see reflation get traction, harming high valuation growth companies and supporting economically sensitive value names.

Given the current uncertainty, sector positions with a value tilt, such as European energy or US industrials, as well as UK equities, can balance out exposures with a growth tilt, such as US equities.

The UK equity market has enough value representation to perform well in the current environment

After underperforming in 2020 and over longer term, the UK equity market has enough value representation to perform well in the current environment.

On the growth side, we expect US equities to continue to grow earnings and generate cashflow. A lot of the promised fiscal spending is intended to stay at home, benefiting US households and firms, and even large-cap US companies have a large tilt towards domestic revenues.

For that reason, the US still represents a legitimate source of exposure to the reflation theme and is a good way to maintain a balanced position in the growth versus value conundrum.

European energy

In terms of sectors, as mentioned we are positive on US industrials and European energy. For the latter, earnings reports have underlined additional points to consider.9

European energy companies are relatively diversified with substantial refining, chemicals and, increasingly, renewable energy businesses. However, their traditional extraction and warehousing activities mean that rising oil prices should still have a positive earnings impact.

Oil enjoyed a strong 2020, but after a quiet period in early 2021, it has again started to recover, reaching $69.70 a barrel as of May 5.10

We previously noted the oil price was lagging the general economic recovery, and there would be upside for energy companies when it caught up. However, these companies face other challenges, particularly in terms of decarbonisation.

A key question for investors in European energy companies – which are more committed to decarbonisation than their US counterparts – remains whether they can both deliver credible long-term net-zero emissions plans and increase distributions to shareholders. While they cut dividends aggressively going into the pandemic, they have now resumed distributions to shareholders. Shell has increased its dividend while BP has announced a new buyback programme; this suggests the companies believe they can deliver on net zero and increase distributions – which is positive for the sector overall.11,12

European energy stocks rose by 2.3 per cent on average in the five days following earnings reports

In addition, although the sector’s average revenues were slightly behind expectations, the earnings surprise was 39.3 per cent above consensus. Coupled with good news for shareholders in terms of cash distributions, this led to European energy stocks rising by 2.3 per cent on average in the five days following earnings reports.13

Investors are starting to see what they hoped they would, not just in terms of earnings versus expectations, but also in terms of European energy companies’ future plans.

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