Keep your eye on the relevant ball

Keep your eye on the relevant ball

19-10-2020 | Column
I know a lot, really. Maybe not enough, but definitely a lot. And it feels like too much. I am bombarded by data points, comments and forecasts on all aspects of the current state of the economy, different scenario analyses on the timing of a vaccine, the odds of who will win the White House, and even the likelihood that at some point we will see the long-awaited resurgence of inflation. But, is all of this information relevant in helping us decide how to allocate our money into year end, and even as a long-term investor? I don’t believe so.
  • Fabiana Fedeli
    Global Head of Fundamental Equities

Speed read

  • Second Covid-19 wave unlikely to halt economic recovery 
  • US elections more relevant for stock selection than for direction 
  • Polarization means not all stocks and markets are richly valued 

Our priority as investors, in this maze of real-time information overload, is to figure out which of these datapoints and forecasts are relevant. Hence, as always, we have to keep our eye on the ball – and this requires us knowing which of the many balls thrown into the air is the relevant one. Equally important is the timing of our focus on that ball: a view on inflation potentially coming back sometime from 2022 onwards does seem like an easy but not particularly game-changing consideration for what I will be doing now with my portfolio, even as a long-term investor. 

In our previous quarterly outlook, we maintained our stance (from earlier this year) that the equity markets of countries that were able to resume their post-Covid-19 economic activity earlier than others would fare relatively better. This meant North Asia was first on our list (which included China, Taiwan and South Korea), followed by Europe. We also believed that it was unlikely that we would have another leg up in equity markets as strong as the one that we had witnessed in the second quarter, especially in the US. We felt that a cooldown period was due, and possibly some profit taking. We argued that the next stage of market upside will have to come from the more cyclical stocks. These, however, needed better visibility on an economic pickup, and that was not evident at the time.  

All of our conclusions from our previous outlook remain valid with the caveat that some events have already unfolded. We have now had the pullback, driven by Nasdaq, and North Asia has outperformed both the S&P 500 Index and the Nasdaq Composite Index in US dollars with some help from stronger currencies. Europe, on the other hand, managed to outperform until the first half of September, driven by currency gains, but lost relative performance afterwards as a resurgence of the Covid-19 outbreak spooked markets.  

We continue to prefer North Asia, followed by Europe, and we advocate for selective buying in higher-quality value stocks

We continue to prefer North Asia, followed by Europe, and we advocate for selective buying in higher-quality value stocks. We also like sustainability as a theme. While we recognize that there is a lot of noise in the market, we don’t see any new relevant datapoints to reach a different conclusion. So, the question becomes: what matters most right now for our investment decisions and what matters less (or doesn’t matter)? 

A vaccine is not the only answer

I see market expectations getting gloomier, and this has affected the performance of European stocks in particular. After the initial shock, macro data in Q3 surprised to the upside compared to very downbeat expectations. The market now fears that the momentum of the recovery is fading and the positive surprises have ended. However, the market may be more concerned about it than it should be.  

I don’t believe new and extended lockdowns will stop the recovery as this second wave seems less severe than the first one, at least in Europe. Admittedly, the number of Covid-19 cases has increased significantly, but this is most likely driven by a significant rise in test availability. Mortality rates have meaningfully declined, as vulnerable individuals, medics and governments have a better understanding of how to deal with the disease.  

There is also a growing number of effective therapies, two of which are already approved for Covid-19 (Dexamethasone and Remdesivir), two of which are widely available and approved for other indications but not yet for Covid-19 (Tocilizumab and Baricitinib) and two more that are likely to be approved in the near future (one of which, Regeneron’s neutralizing antibodies, was used for President Trump). 

Hence, I am not overly concerned if a vaccine will be available in March, April or May from an investment perspective (obviously I am from a human standpoint). The one point that concerns me is the lasting effects of Covid-19 on some companies. The first wave of government support to companies and workers is nearing the end, and new support schemes – even if approved – are likely to be less generous.  

Some signs of weakening on the employment front are already evident in the US, where unemployment data shows that companies have continued to replenish the jobs lost earlier in the pandemic but at less than half the pace than in the summer months. We are also starting to see the headlines of large companies’ layoffs. At the same time, US personal income in August declined, largely due to the lapse of some of the unemployment benefits. Clearly, the much-debated stimulus package in the US would help alleviate some of the pressure on the consumer and support the economy until momentum improves. Hence, for me, a protracted delay in the approval of a stimulus package would be a reason for concern about US domestic demand. 
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US elections are more relevant for selection than for direction

Much is being discussed about the possibility of a contested US election but I am more concerned about what will happen in Congress. Clearly, a contested presidential vote would rattle markets in the short term. In the end, however, we will have a president of the United States, and having a winner – independently from who that is – will most likely have markets breathe a sigh of relief.

Either candidate would look to implement stimulus measures for the economy. In the event of a Biden victory, we would likely see a preference for public investment, and more concern for the environment. This would affect stock selection. A split Congress, however, would make any stimulus policy more difficult to implement and – hence – less effective. I would take a contested presidential election any time over a split Congress.

Not all markets are richly valued, there are options out there

As a portfolio manager trained at the school of value, I have sympathy for investors’ concern about valuations, and the likelihood that in some cases these have run ahead of fundamentals. Yet, the current market polarization implies that not all markets – and certainly not all stocks – have reached nosebleed performance and valuation levels. Over the last ten years, the Nasdaq Composite Index topped the performance of the world’s largest equity markets, followed by the S&P 500 Index. Other markets have vastly underperformed.

Relative valuations are also far more reasonable than the 21x FY20 PE of the US market, with China’s CSI 300 trading at 16.7x FY20 PE and Europe at 16x. Clearly, earnings growth will be the real discriminant, and this is what we need to continue to monitor. Thus far, the differential in the earnings growth outlook between the US, Europe and North Asia does not warrant such disparity in valuations.

Closer to the end

So, our base case remains that the global economy will continue to improve, although at a slower pace than what we have seen in the third quarter. Monetary policy will maintain a floor under the economic momentum, while fiscal policy, with some occasional cliffhangers, will also offer a helping hand. Overall, this means support for global equities, particularly as the earnings yield derived from current valuations remains compelling in the current low interest rate environment.

Yes, we have hit a road bump. But not an unexpected one. While a second Covid-19 wave is not a blue-sky scenario, it is also not the end of the economic pick-up.

Importantly, we are closer to the end of the sources of uncertainty than to the beginning, whether it is the US elections, a Covid-19 vaccine or the approval of more therapies. Even Brexit, while still unclear, can be pinned down to a range of – admittedly not great – scenarios. This doesn’t mean that it will be plain sailing from here, just that we are either getting past the worst of the typhoon, or that our sails are getting stronger.

Our investment teams have continued to selectively take profit from stocks with stretched valuations and have added to quality laggards that are expected to benefit from recovery in some (but not all) areas of the economy.

For all of the teams, in the choppy waters of macro uncertainty, stock selection has kept the rudder steady. Some stocks will need longer to recover from the post-Covid-19 effects, if they ever will, and it is wise to continue to avoid them until we get more clarity on what the future holds. Importantly, in a news-driven volatile market, staying patient and picking our entry points was and remains the name of the game. Technology stocks remain an overweight in many of the portfolios. This is true also for US technology, although we have been actively lowering the position.

North Asia and Europe remain the largest overweight positions in our global portfolios. Within EM, we are also selective at a country level, and while we have continued to increase our positions in China, Taiwan and South Korea, we remain cautious on Latin American and EMEA economies.

With the many balls being thrown in the air at the moment, keeping our eyes peeled on the relevant one will make the difference in our investment performance.

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