Monthly Investment Letter: Reversion to the trend

If every vaccinated consumer acts like my 82-year-old father, the economic rebound could surprise to the upside. He has canceled streaming services that helped drive the “stay at home” trade and hit the road to travel. Should he be driving? Should he be stopping at every barbecue joint that crosses his path? That’s a different conversation. The point is that we are in the middle of a “catch-up” trade that we think will continue.

The shift in equity leadership toward last year’s laggards, which we have been highlighting for several months, has been given a further boost by the passage of the USD 1.9 trillion fiscal stimulus package in the US. Sectors like energy and financials have rallied significantly. Rising bond yields have contributed to the strong performance of value stocks relative to growth and technology stocks.

This “reversion trade” means that most of the dominant short-term trends in markets are the opposite of the long-term trends that have persisted for a decade. Investors are left asking: How much further does reversion have to run? And are the long-term trends still intact? We consider these two questions in this letter.

With inflation, stimulus, and an accelerating economy all influencing markets in the second quarter, we think investors should still be positioned tactically for a continuation of the “reflation trade,” particularly in energy, financials, and small caps. All of these sectors should benefit from a more robust economy, and higher yields. This environment is likely to continue to create near-term volatility and uncertainty for some growth stocks, but should not change their structural earnings growth potential, which is the key driver for long-term returns. As such, longer-term investors should consider how to use a period of potentially elevated volatility to build up strategic positions in select growth themes.

For more details on how to position for today’s market environment, refer to our 2Q outlook report, “Positioning for a post-pandemic world: Our outlook for 2Q.”

The hunt for yield: navigating the bounce

In my last letter, I spoke about how a coming “spike train,” of inflation, stimulus, and growth would create heightened macroeconomic uncertainty. This is playing out most acutely in the bond market. After starting the year at just 0.9%, 10-year Treasury yields have increased to more than 1.7%.

After the jump in yields, Fed fund futures are now pricing one 25-basis-point interest rate hike from the Federal Reserve in late 2022 and two more in 2023. This is far ahead of the central bank’s own projected path for rates: Its “dot plot” indicates rates will remain on hold through the end of 2023. This means there is limited upside for short-end rates. However, the Fed’s plan to allow the economy to ‘run hot’, means that the yield curve may continue to steepen, as the market may begin to price the probability that inflation rises more quickly and persistently than the Fed has projected, which would require them to accelerate the pace of future hikes beyond what has been guided. In our base case we expect nominal 10-year yields to end the year close to 2%.

Is this the end of ‘lower for longer’?

Some economists argue that the current upward move in yields reflects a structural change in the market regime, driven by US fiscal stimulus. Former Treasury Secretary Larry Summers, for example, believes “there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation.”

I think it is important to remember that inflation has repeatedly failed to push sustainably above 2% for most of the past decade, in spite of ultra-loose monetary policy and the Trump administration’s stimulus of an economy already close to full employment. Increased government indebtedness following the pandemic creates an even stronger need for continued financial repression to ensure debt financing is sustainable. Longer-term disinflationary pressures remain in place, most particularly the lower productivity growth of economies dominated by services, and the reduced demand for labor from the application of technology.

That said, in the months ahead investors will need to continually monitor the path of US fiscal stimulus, inflation expectations, and projections for productivity growth, to gauge whether we are indeed breaking out of the ‘secular stagnation’ regime which has persisted since the Global Financial Crisis.

What does our yield outlook mean for equities?

Even with the increase in bond yields, for longer-term investors we think it remains the case that “There Is No Alternative” to equities. Comparing the S&P 500 to US Treasuries over the next decade, dividends alone are likely to provide more income than bond coupons, and that’s before we consider the returns from buybacks and likely capital appreciation from stocks.

In the near term, there is more uncertainty due to the effect bond volatility can have on stocks. In the past 25 years, there have been 10 periods in which the 10-year Treasury yield has risen by more than 100bps, and in all instances global equities delivered flat or positive returns. Rising inflation expectations also tend to reduce equity risk premiums. That said, all else equal, higher yields do present a headwind for equity valuations.

Despite rising yields current valuations are above the long-term average for the equity risk premium. Using our 2022 earnings forecast and current market levels, a 2.25% yield would imply an equity risk premium of around 2.95%, within the 2015–21 range of 2.85–4.7%, and above the 25-year average of 2.75% and the 35-year average of 2%.

Positioning for reflation: The value and cyclical trade has more to go

The 69% recovery in the MSCI World Value index since 23 March last year has brought the segment back to pre-pandemic levels. However, while the recovery has been significant, it remains small in the context of the extent of the underperformance relative to growth over the last 15 years.

In our base case, we think the rotation into value and cyclicals will continue in the near term, supported by the broadening recovery and faster growth. Globally we prefer sectors that benefit from accelerating industrial production and rising inflation, such as materials.

We expect financials and energy to perform well in this environment. Even after their recent gains, financials and energy have underperformed the S&P 500 by 9% and 33% respectively since the end of 2019, and we see potential for further catch-up. Financials clearly benefit in a reflationary environment of higher yields and a steeper yield curve, but they also benefit from stronger growth via a reduction in nonperforming loans and the positive impact on earnings revisions from lower loan provisions. Valuations are also attractive: the forward price-to-earnings (P/E) ratio of global financials relative to the broader US and European market is more than 2 standard deviations below the long-term average. Globally, we prefer select financials.

We also like oil, supported by our expectations for a strong recovery in global activity and OPEC’s continuing production restraint—we think Saudi Arabia will only increase output based on evidence of robust demand, rather than adding supply proactively. Our year-end Brent crude oil price forecast is USD 75/bbl. We think US energy stocks in particular should benefit from this. The sector has the highest free cash flow and dividend yields in the S&P 500, and has not fully priced in current oil prices.

Given their high correlation to yields, energy and financial stocks are also attractive hedges in a portfolio context, should interest rates go even higher than we expect. We also see potential for continued outperformance for small-caps over large-caps, given their cyclical exposure, and valuations that remain historically attractive. The price-to-book value ratio of MSCI World small-caps relative to the MSCI World is almost 2 standard deviations lower than the long-term average.

Is the ‘value trade’ any more than a ‘trade’?

The longer-term prospects for the “value trade” hinge largely on whether the “secular stagnation” regime of low long-term growth, low inflation, and low interest rates persists.

If a new paradigm consisting of sustainably higher nominal growth and higher yields emerges, the value trade could run for years. Value stocks’ performance has tended to be more positively correlated to rising yields than growth stocks. But value also benefits from faster economic growth. Over the last 20 years, when nominal GDP growth in the US has been greater than 4.5%, earnings of value companies have outpaced those of their “growth” peers.

Investors should take the opportunity to build some exposure in value, both for near-term performance and as a hedge against a potential change in the market regime.

Structural growth: on sale?

In the initial months of the pandemic, technology stocks delivered significant outperformance as the stay-at-home trade and lower rates supported the sector. But the positive vaccine developments starting last November drove a divergence within the technology sector. Gains for mega-cap tech stocks—among the primary beneficiaries of the stay-at-home trade—began to moderate. Yet the Nasdaq continued to rally strongly—and actually outperformed the S&P 500 by 6.5 percentage points between November and February—thanks to the hunt for post-pandemic technological winners. Since the start of November, mega-cap tech is up 7%, while a basket of profitless tech companies is up 38%.

More recently, the rise in 10-year Treasury yields has undermined the sector. Growth stocks are long-duration assets and their valuations are negatively impacted by rising nominal yields. The S&P 500 has rallied to a new all-time high, but tech has underperformed, with the Nasdaq still –4% away from its 2021 record high. Underperformance has been strongest among the early-stage companies that have yet to generate profits. These had been among the strongest performers—up 68% between November and the February peak—but the long duration of their potential future cash flows means their valuations are also most affected by higher yields. If there is no offset from growth, a rise in 10-year yields from 1.5% to 2% would reduce the valuation of a tech stock trading on an enterprise-value-to-sales ratio of 12x by around 15%.

That said, we do not think this is the beginning of the end for tech investing. For growth companies, delivering on long-term earnings growth is much more important than starting valuations, and we still expect tech earnings growth of around 20% this year. Over the next five years, we expect a low- to mid-teens percentage compound annual growth rate (CAGR) for global tech earnings. That kind of growth turns what looks like a 26x P/E today into a 16x P/E by 2025.

As such, we think near-term volatility can be seen as a potential opportunity to build longer-term positions in the following areas:

• Large-cap tech companies with established business models and reliable revenue visibility, including select global platform companies, proved more defensive than other tech during the recent correction, remain well below their November peaks, have less demanding valuations, and offer steady earnings growth.
• The more cyclical semiconductor sector is now more attractively valued after the recent correction, and pricing is firm amid tight global supply and 5G-driven demand. We think chipmaking equipment manufacturers in particular will benefit from aggressive near- to medium-term capital expenditure. Global memory chipmakers also offer value.
• We like “subscription economy” companies for their steady revenue growth, solid cash flow generation, and capacity for margin improvement. We see the digital subscription market growing from USD 650 billion last year to USD 1.5 trillion in revenue by 2025, an annual growth rate of 18%, making it one of the fastest-growing market segments globally. We recommend investing through a diversified mix of leaders in the enterprise and consumer digital subscription segments, and favor mid-cap stocks in both developed and emerging markets.

China: too distinct to ignore

Between 18 February and 18 March, China’s CSI 300 index fell 11.5%, on concerns that China is seeking to tighten monetary policy, and a perception that growth targets set by the National People’s Congress were relatively conservative. However, both on a tactical and a strategic basis, we think this is a good time for investors to consider adding to allocations in China and Asia.

In the near term, we think Chinese stocks are now oversold. Despite Premier Li Keqiang setting this year’s GDP target at just “over 6%,” we expect China’s GDP to grow by 9% in 2021, driven by higher consumption and investment. Our bottom-up earnings-per-share growth forecasts for Asian equities are 22% in local currency and 28% in US dollar terms in 2021.

Strategically, we think allocations to Asia and China are crucial for long-term portfolio returns and diversification. The West-to-East shift in economic power has continued during the pandemic. We expect that by the end of 2022, real GDP will be 9% higher than it was in December 2019 for the US, but 18% higher for China. Yet many investors remain under-allocated to the region.

Asia will also be home to some of the most compelling growth opportunities in the years to come. For example, by investing in China’s intelligent infrastructure segment, including 5G, investors gain exposure to companies that we expect will see double the rate of earnings growth of the overall market in 2020–21. We forecast that China’s green ambitions will drive a twofold rise in solar instalments, 40% growth for wind instalments, and a five-fold increase in electric vehicle (EV) production by 2025. And with China already the world’s largest e-commerce market and set to become the first large economy to introduce a digital currency, we retain positive views on China’s leading internet platforms, select banks, and global fintech leaders.

Scenario analysis

For the past year, we have anchored our scenario analysis around the pandemic. Today, with vaccination rollouts underway, the uncertainty related to the coronavirus has been reduced. Recent volatility demonstrates that the potential future path for interest rates and inflation has taken over as the most consequential market driver.

Inflation and interest rates are somewhat complex market drivers, because, depending on the circumstances, “higher inflation” or “higher rates” could be good or bad for markets. To reflect this more complex picture, we provide a more detailed scenario analysis in this letter. But overall, in most scenarios, including our base case, we continue to expect further equity market upside.

In our base case scenario, the rollout of vaccination programs will enable economies to reopen fully, boosting growth that will be further spurred by fresh US fiscal stimulus and continued monetary support from global central banks.

In this scenario, we believe official policy rates will remain unchanged by year-end, but we think longer-term yields could rise as the market begins to price the possibility of inflation surpassing the Fed’s projections. Based on our 2022 S&P 500 earnings forecast of USD 205 per share, we derive a year-end target for the S&P 500 of 4,200. Within this scenario, there is a risk that the market may begin to perceive the Fed as being behind the curve if it does not respond at all to rising inflation. But given that this scenario would also likely mean higher growth and corporate earnings, we would still expect the S&P to end the year at 4,200, albeit with higher yields and inflation expectations.

Investment recommendations

As growth and inflation bounce, earnings return to trend, and economies reopen, we think this is an important time for investors to reassess their tactical and strategic positioning for the current market environment. For more details on how to do this refer to our 2Q outlook report, “Positioning for a post-pandemic world: Our outlook for 2Q.”

Position for reflation

We think the value trade has further to run, and think investors should continue to position for reflation. Higher growth, inflation, and yields should help support the energy and financials sectors “catch up” on their underperformance in 2020. We also see potential for continued outperformance for small-caps over large-caps. For more, see pages 4–5.

Hunt for yield

While bond yields have risen in recent weeks, across most of our scenarios we expect risk-free yields to be below the rate of inflation for the foreseeable future. As such, long-term investors will need to find ways to replace negative real yielding assets like cash, with assets that have positive real yields, including dividend stocks, or parts of the credit spectrum.

This month, we add a preference for US high yield (HY) bonds and US senior loans. The strong economic recovery we expect in the US should limit defaults, and as a result of a 10% default rate in 2020 and fallen angels entering the segment, average credit quality in HY has improved. Higher oil prices will support earnings and viability for the energy sector, which accounts for around 15% of the index. Furthermore, HY should be more resilient than investment grade (IG) in a rising rates environment. Historically, there is a negative correlation between the HY-IG spread differential and 10-year US Treasury yields. The positive outlook for the recovery and corporate default rate also supports senior loans, which, as a floating rate asset class, have minimal interest rate sensitivity.

We also continue to like Asia high yield credit, which has a yield in excess of 7%, and we expect total returns of 7–8% by the end of the year.

Use volatility to invest and protect

An elevated volatility environment means that buying outright downside protection is currently expensive. For example, the cost of S&P 500 put options has more than doubled from the lows of January 2020.

However, that elevated volatility also presents opportunities to invest and protect. For example, option volatility “skew” is currently elevated, meaning that the price of put options is high relative to call options. This makes it cheaper to buy combinations of options, like bullish risk reversals, with asymmetric payoff structures.

Our view remains that the broadening of the economic recovery will reduce demand for safe-haven currencies, like the US dollar, while also benefiting more pro-cyclical currencies, like the euro. The scale of US fiscal stimulus has raised concerns about the sustainability of debt financing, which could also weigh on the greenback. That said, in the near term, the dollar has benefited from the sharp rise in US yields, which could continue if rate volatility persists. Currency market volatility remains low both historically and relative to equity market volatility. Option strategies that benefit from additional USD strength therefore offer a cost effective means of hedging against a further rise in US yields.

A higher-volatility, lower-correlation environment should also provide fertile ground for select hedge fund strategies to outperform. For more information please see our report “Q&A: What do allocators use hedge funds for?”

Position for structural growth

Volatility in growth stocks could continue in the near term as the market adapts to the reflationary environment. However, we continue to see long-term appeal across the growth and technology spectrum and think investors can use pullbacks to build longer-term positions in themes including 5G, fintech, greentech, and healthtech.

We also see opportunity among some of the larger platforms and in subscription businesses, which, given their established and cash-generative business models, should prove more stable in the near-term.

Seek opportunities in Asia

We think this is a good time for investors to consider adding to allocations in China and Asia, both on a tactical and a strategic basis. Within the region, our most preferred equity markets are China, India, and Singapore. In particular, we expect China’s equity market to be supported by strong earnings and a better liquidity outlook following the recent spike in the domestic repo rate.

Go sustainable

We continue to expect parts of the sustainable investing universe to experience rapid revenue and profit growth in the years ahead. Greentech stocks have rallied significantly as global policymakers have emphasized the green agenda. That said, after strong performance in certain sustainable investing themes, it is becoming more important for investors to think carefully about selectivity, portfolio construction, and broadening thematic selection.

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