Monthly Investment Letter: Roadmap to recovery

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Last month, I wrote that we expect markets to experience heightened volatility, notably around the US election, but that investors should use this time to position for higher stock prices over the medium term. We think this is still the right view to hold and plan to pursue. Although a recovery remains on track in China, US politics and the increase in COVID-19 cases in Europe have reduced the visibility around the economic and asset market outlook.

Some investors may be tempted to wait for more certainty before committing capital. But our view remains that it’s better to look beyond the near-term uncertainty and start to build long-term positions now. Whatever the outcome of the US election, we think new stimulus will roll out after the vote and lift economic growth. Successful Phase 3 vaccine trials, or the approval of an effective treatment for COVID-19, would also improve visibility on the medium-term outlook. And with central banks around the world telling us that interest rates will remain close to zero for the foreseeable future, being invested is the only option for those who want to protect and grow real wealth over the long term.

Despite our conviction about rising asset prices, we recognize many investors can’t ignore volatility.

Downside risks make it more important to invest in a manner that is disciplined and diversified in the context of a robust financial plan. Investors should also remember that volatility can also create opportunities—to implement tactical positions, to improve portfolio yields, or to invest gradually at a deliberate pace.

Overall, we like equities, particularly the more cyclical parts of the market that we think have scope to drive the next leg of the rally. These areas include the UK, US mid-caps, and small- and mid-caps in the Eurozone. Heightened levels of volatility and skew in options markets are creating a window to reduce the cost of upside exposure to Eurozone equities. We also still see attractive opportunities in the credit space for yield-seekers.

Why investing now makes sense

1. The US election will unlock new stimulus

The shape of the VIX futures curve tells us that election-related volatility could last longer than usual this year. Given the above-normal number of votes cast by absentee ballot, and the possibility of President Donald Trump contesting the election outcome, we should prepare for the likelihood of political uncertainty beyond 3 November. The last time the result of the US presidential vote was contested—between George W. Bush and Al Gore in 2000—the S&P 500 fell almost 5% between Election Day and 13 December, when Gore conceded. Now that a preelection stimulus plan is in question, a prolonged period of uncertainty would be a further detriment to the US economy.

Yet the polling lead of former Vice President Joe Biden has reduced market fears of a chaotic transfer of power. Moreover, the Democrat-controlled House of Representatives has already passed a USD 2.2 trillion stimulus package, which is indicative of the path the US government would take if Republican opposition is overcome. Both factors have likely contributed to the recent rise in equity markets and 10-year Treasury yields. Although a Blue Wave victory by the Democrats would likely lead to higher taxes and tighter regulations over the medium term, in the near term the indicated fiscal stimulus is leading to expectations for higher growth and inflation. Good nominal growth would reduce the risk that the Federal Reserve is forced to impose negative rates.

After a Blue Wave, the second most likely outcome is a split presidency and Congress. This scenario presents the risk of policy gridlock, which would further contribute to volatility. But even in this scenario, we would expect some stimulus measures to pass. The Senate Majority leader has not ruled it out, and President Trump now claims he is in favor of a large support package.

Finally, it’s worth noting that while the polarization in US politics makes the election result “feel” like a major risk for markets, historical evidence speaks for looking past the voting outcome. Since 1932, excluding 2008, the S&P 500 has typically generated slightly positive returns one month prior to Election Day. And after some immediate postelection volatility, the returns have typically been positive regardless of a Democratic or Republican victory.

2. Successful vaccine trials will increase certainty about the economic outlook

Recent developments in Europe show that, in the absence of COVID-19 vaccines or treatment advances, governments may choose to slow or reverse reopening economies to manage the spread of the virus. As long as this remains the case, uncertainty over the path of the economic recovery will persist, and volatility will remain elevated.

Critical Phase 3 efficacy data for the most advanced vaccines in development is likely this month or next. After allowing for additional time to gather more safety data and for regulatory review, we think either or both of Pfizer/BioNTech’s and Moderna’s vaccines could receive authorization for emergency use in December. It would likely take until the second quarter of 2021 to have sufficient doses to vaccinate half of the US population. But we think that markets will already start to price in the economic benefits of a vaccine as soon as positive results on its efficacy are published, as it will provide greater certainty that governments will not need to use lockdowns to manage the virus indefinitely.

Even in the absence of a vaccine being approved this year, improvements in the treatment and management of the virus, combined with the fact that recent case growth has been tilted toward younger people, have contributed to lower mortality rates in the US and Europe. Two companies, Regeneron and Eli Lilly, have shown early data demonstrating that antibody treatments can reduce viral load and may hasten the reduction of symptoms. While none of the new treatments, including remdesivir, constitute a definitive “cure,” and progress in trials has been subject to some routine setbacks, a growing armory of drugs is reducing the burden on health systems and improving patient outcomes. In this light, amid the increasing resistance to the reimposition of restrictions in Europe, we think governments will continue to favor targeted, localized measures.

3. Central bank policy is making the long-term case for equities over cash even clearer

Central banks have told us we should expect rates to remain close to zero for the foreseeable future: The Fed projects that rates will be on hold until at least the end of 2023. At the same time, the shift to average inflation targeting suggests policymakers may be willing to accept a period of moderately higher inflation. For investors looking to draw on their savings to fund their spending, this combination of factors makes it more important to be invested in growth assets.

Stocks can experience significant losses in a short time period but have consistently provided solid long-term returns. Since 1928, based on data from Bloomberg, stocks have outperformed cash in 69% of one-year periods, 84% of 10-year periods, and every single 20-plus-year investment horizon.

One can argue that, given aging populations and weak productivity growth, the best days for equities are behind us. But for stocks to underperform the safest assets over the next 15 years would require a truly unprecedented set of circumstances. US bond yields imply that investors would earn around 11% over the next decade-and-a-half in assets like cash or government bonds. Yet equity dividends alone (on the S&P 500) will provide a 25% return over this period even assuming no dividend growth—something that hasn’t happened since 1945. Taking this into account, the equity market would have to fall by more than 14% over the period to underperform. The worst-ever 15-year price performance for the S&P 500 was a 6% decline starting August 1929.

Scenario analysis

In our central scenario, we think markets will move higher over the medium term. As conditions normalize into 2021, we expect earnings growth and a slightly lower equity risk premium to drive the S&P 500 to 3,700 by June 2021.

In our upside scenario, prompt passage of a substantial fiscal stimulus and widespread availability of a vaccine in 1Q21 would accelerate the base-case recovery.

Of course, amid heightened uncertainty, we could be proven wrong. But, given the strength of the long-term case in our view, a downside scenario would have to involve at least one of the following big events:

• An effective vaccine does not materialize before 2H21, meaning governments are forced to use restrictions on business activity or even full lockdowns in 1H21 to manage the virus.
• US lawmakers fail to agree on a fiscal stimulus and the Fed does not respond effectively.
• Tensions between the US and China take a decisive turn for the worse, leading to renewed tariffs or sanctions of major Chinese companies and financial institutions sufficient to derail growth.

If one or more of these events materialized, in our downside scenario we estimate that the S&P 500 could fall to 2,800 by June next year. In these circumstances, we would expect only a limited recovery in corporate earnings in 2021, rather than the 27% growth in our central scenario, and for the price-to-earnings (P/E) ratio to level off at 18x.

Based on the data we have, and for the reasons described above, each of these events currently appears unlikely. Evidence points to a vaccine being authorized in the US by the end of this year. Both Democrats and Republicans are in favor of further stimulus, and the politicization of the debate is short-term driven by the election. Both the US and China have reaffirmed their support for the Phase 1 trade deal, signaling a desire to continue trade despite tensions.

How to invest

Strategically, the most important action investors can take is to make sure they are invested, and diversified, with a robust financial plan. As Figure 4 shows, cash lump sums can deplete quickly when we consider the possibility that personal spending rises more rapidly than interest rates. Being invested purely in equities offers the possibility to grow wealth while making withdrawals, but does come with higher uncertainty. For most investors, a diversified portfolio offers a better balance of risk and reward.

Tactically, we think investors need to put measures in place to take advantage of near-term volatility, and position for markets to rise over the medium term.

Diversify for the next leg

As I wrote last month, the rally since March has been strongest in the stocks and sectors exposed to the “new normal,” like US mega-cap technology stocks. But going forward we see greater potential to diversify into other stocks within and beyond technology that we think will drive the next leg of the rally.

Diversify within technology

5G. We see an opportunity for investors to diversify their technology exposure. Although US mega-caps have performed very strongly year-to-date, we think the next leg of the rally will fall to other areas within the growth and technology space. In particular, we think direct and platform beneficiaries of 5G could benefit from increased attention in light of the launch of the new iPhone.

Greentech. Europe is on the cusp of history’s biggest green stimulus program. The EU has agreed to a fiscal stimulus package worth EUR 1.85 trillion over the next seven years, more than 30% of which will be used for climate investments and “green” economic growth. We see significant implications for most sectors, especially power generation, transport, industry, and building (heating and cooling), which account for about 80% of European greenhouse gas emissions. Greentech leaders offer multiyear opportunities across industries. While the European Green Deal is a longer-term plan, we also see investment potential in the short to medium term.

Diversify beyond technology

US mid-caps and European small- and mid-caps. Rather than make a call between growth and value, tilting toward mid-caps offers investors more cyclical exposure without necessarily underweighting growth. Economic uncertainty has disproportionately dragged down valuations of stocks outside of the mega-caps, and we expect them to recover as more confidence returns. We continue to expect smalland mid-cap earnings growth to outpace large-caps’ over the next year, which should be a key driver of our conviction on this size segment.

In the US, based on next year’s earnings estimates, the Russell Mid-Cap index trades at a P/E that is about 5% lower than for the Russell 1000 index. This looks attractive relative to the 5% average valuation premium in the 10 years before the pandemic. In Europe, while small- and mid-caps have traded at an average 5% premium versus large-caps over the last 15 years (based on trailing 12-month price-to-book), they are currently trading at a 17% discount. The return on equity for EMU small- and midcaps is now 8.5% versus 9.2% for large-caps—a small gap that we believe does not justify such a large difference in valuations.

EM value. We think that after a decade of underperformance, value should catch up amid a cyclical recovery in emerging markets (EM). Value also offers attractive dividend yields in a low-rate world and is less exposed to concentration risk. Based on past episodes of value catch-up in 2016 and 2018, we think EM value has the potential to outperform the MSCI EM index by 10–15% in the next 6–12 months in up and down markets. In our baseline scenario, we expect the next leg of the EM recovery rally to be driven by high-dividend-yield value stocks in the financial, energy, materials, and real estate sectors that have lagged in the past. These sectors, especially financials, offer greater scope for earnings recovery at a cheaper valuation as economic growth reaccelerates.

The UK. The FTSE 100 is still 24% below its January high, making the UK one of our most preferred equity markets. It is trading at a 30% discount to the MSCI All Country World index, compared with a 10-year average of 10%. We think the worst of the earnings contraction in the UK is behind us, favoring a significant earnings rebound in 2021. The UK’s sector composition is also a favorable mix of defensives, such as healthcare, and cyclical value, such as energy and basic materials, which would benefit from a global recovery.

Take advantage of volatility

A period of heightened volatility can be unnerving for investors. But we also see it as an opportune time to enhance returns or build up positions for the long term.

Specifically, investors can look for strategies in the options space to gain exposure to cyclical markets or use the elevated volatility in markets like commodities to enhance yield.

For example, we think the skew in the options market is creating a window to reduce the cost of upside exposure to Eurozone equities.

Hunt for yield

Interest rates are likely to remain close to record lows for the foreseeable future, maintaining the appeal of income-generating assets. While spreads have tightened, we still see value in select segments of credit. In particular, we like USD-denominated emerging market sovereign bonds, European crossover bonds, green bonds, and Asian high yield bonds. We also think that ample government support is likely to limit corporate defaults in US high yield, allowing risk-tolerant investors to take advantage of low borrowing costs to leverage returns.

Position for dollar weakness

We also expect a weaker dollar. Fed policy is expansive and under no pressure to shift toward a neutral stance. Chair Jerome Powell said this month that the greater risk is not doing enough to help the economy, rather than too much. Also, while we do not believe the Fed will push rates into negative territory, any discussion that this is under consideration would likely further undermine the dollar. Finally, we think the Democrats’ proposed policy mix of higher taxes, increased infrastructure spending, and greater regulation would weaken the USD relative to its current value against a broad range of currencies, in the event of a Blue Wave.

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