As investors, we never stop learning. If you think that you know it all, then it’s time to retire. Not all lessons are pleasant, but hopefully they will make us better at our jobs. The past three months have taught us three things: 1) We should never dismiss China, 2) The future is greener, especially in investments, and 3) Value is not dead, but is starting to look ever more like my grandmother’s fine china dining set: it gets displayed when there is something to celebrate (better macroeconomic data), only to get put back in the cupboard when life goes back to the everyday worries. These three themes will chart the course to the end of the year at the very least, and most likely to the end of the next decade.
In our last quarterly column, we wrote that the equity markets of countries that were able to resume their post-Covid-19 economic activity earlier than others would fare relatively better. These countries included China, Taiwan and South Korea. Since the end of the first quarter of 2020, and at the time of writing, the performance of the CSI 300, Kospi and TWSE indices all beat the MSCI World Index as well as the S&P 500 Index.
We also highlighted the importance of being selective from an individual stock viewpoint, as once the earnings impact became clear, we would start being able to distinguish the winners from the losers. We still stand by those statements, and were not surprised by the performance concentration that we saw over the last three months.
So, what comes next? A cooldown, if not a pullback, of equity markets is now overdue. That said, a lot will depend on how Covid-19 continues to spread.
Covid-19 is not over yet. From a global perspective, we are hitting new contagion peaks. We are therefore clearly not in a V-shaped economic recovery. For now, we believe we are looking more at a ’U’. There is a chance that this could turn into a ’W’, meaning a double-dip recession, but we see such a chance as limited. Authorities and medics around the world seem to have learned to deal better with the outbreak, and a vaccine appears closer.
As long as we do not return to extensive lockdowns, and central banks and fiscal spending plans continue to support markets, there is likely to be further support for equities. We believe it is unlikely, however, that we will have another strong leg-up, especially in the US. A cooldown period is due at this point, and possibly also some profit taking.
The next stage of market upside will have to come from the more cyclical stocks
The tech-savvy stocks that have driven the upside in both developed and emerging markets may not plummet, as their earnings are well underpinned by fundamentals, but it is difficult to see them continuing to perform at the same pace. The next stage of market upside will have to come from the more cyclical stocks. These, however, need better visibility on an economic pickup. Clearly, the all-time high in dispersion between value and growth would support the switch, and the market seems to be waiting for it.
So, what does this all mean for portfolio construction? Until the virus is under control, from a regional perspective we continue to favor countries that have been dealing more effectively with the outbreak. This means looking at North Asia and Europe. From a stock selection perspective, we have been taking profit from some of the high-flying compounders and have added to cyclicals and stocks that have underperformed, but still have solid fundamentals.
These stocks may have been wounded by the coronavirus, but we expect them to recover. We have, however, remained selective regarding the quality of those less defensive positions due to the risks of a slower recovery. Given how polarized the market has been, there are enough of opportunities to pick from without going too low on the quality scale.
We also see three clear trends unravelling as the path to normalization continues.
Firstly, our constructive position on Chinese equities, particularly A-shares, is not a consensus one. After the recent rally, and given the anti-China US rhetoric, one might wonder why we are still constructive on this market.
Besides the effective handling of Covid-19 and earlier economic recovery, there are structural reasons. China is the second-largest economy in the world and its equity market is significantly under-represented in investors’ portfolios. This is partly due to the diffidence of investors and concerns around transparency, and partly to the low inclusion of Chinese companies in equity indices.
Chinese authorities recognize that it is in their interest to further open the mainland equity market to foreign investors, and have made significant steps with the Stock Connect program and the removal of quotas on the Qualified Foreign Investor program. Such increased access should also allow for more inclusion in equity indices going forward. We also like the choice and depth of exposure enabled by A-shares.
For the rest of the year the Chinese equity market should be underpinned by improving macro data and the ongoing capital market reforms. In addition, even after their recent rally, A-shares trade not far from historical lows, in terms of valuation relative to US equities.
Short term volatility is likely, either due to the government trying to quell the animal spirits of retail investors, new outbreaks of Covid-19 or an escalation of the US-China conflict. But while we do not expect a de-escalation of the latter, particularly in the run up to the US elections, we believe the impact of such tensions on investors’ sentiment toward China is diminishing as China seems to be able to deal with everything it is thrown at.
The second trend is a pivotal shift across the world. If ‘’follow the money” is still a valid mantra, then ‘’go green” should follow suit. Sustainability is becoming increasingly important for public opinion and a growing number of governments. While governance has played a key role in investors’ minds for some years, it is now becoming increasingly clear how the environmental impact of companies will play an even bigger role on their financial outlook. Covid-19 has been an accelerator. As governments pledged fiscal support, they have made it clear that the focus will be on creating a more sustainable world ahead.
When presenting the European Commission’s EUR 750 billion economic stimulus plan, Commission President Ursula von der Leyen stated: “If it is necessary to increase our debt, which our children will then inherit, then at the very least, we must use that money to invest in their future, by addressing climate change, reducing the climate impact and not adding to it." It makes sense to me.
In Canada, large businesses that apply for government loans in the wake of the pandemic must publish Annual Climate Disclosure Reports. And while the US administration is behind those of other developed countries when it comes to sustainability, the common ground for both Republicans and Democrats is an increase in infrastructure spending. In the event of a Democratic win in November this would likely be more focused on the environment.
Emerging markets are also starting to pull their weight. South Korea recently announced a post-pandemic USD 130 billion Green New Deal investment plan to improve the environmental sustainability of the country. Whether these plans will be fully and successfully implemented is uncertain. The direction taken is clear.
For the third trend, we have all noticed the extreme polarization in value versus growth performance and valuations. Such disparity provides support for a return of value – but support is not enough. We need a trigger. For value to make a lasting comeback, we need an improving macroeconomic outlook.
This was evident by the short-lived rotation towards value seen in the second quarter. It lasted for as long as the outlook for macroeconomic data – and hence for cyclicals – improved. As Covid-19 proved difficult to contain, particularly in the US, value went back to underperforming. It has, however, shown a revival in China and the improvement of macroeconomic data will also be key there.
While any market upside predicated on a brighter future will lift of the boats of value, some are destined to never leave port, and a few will sink
But buyers be aware – while any market upside predicated on a brighter future will lift of the boats of value, some are destined to never leave port, and a few will sink. The notion of value has to evolve. The concept of mean reversion might hold true for some companies, but not for many others.
In a world of technological breakthroughs, where the services and consumption of content of economies around the world increases, retail and information flows have moved online, production processes are more about software than hardware, and sustainable practices are key, our search for value needs to be smarter. Companies that do not keep up with innovation may well stay behind and become value traps. Value is not a synonym for mean reversion anymore.
With every quarter, we learn something new. The most valuable lesson is that we need to be willing to look ahead and recognize that the future – in many ways – can look very different from the past. Not everything will mean revert, while China, sustainability and a smarter way to look at value are three of the new forces that we have to reckon with.
The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).
This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.
This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.