Monthly Investment Letter: Stuck in your story?

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Policymakers of all stripes stuck to their stories after April’s weak US nonfarm payroll report. The Federal Reserve found justification for its continued easy monetary policy; President Joe Biden saw confirmation of the need for continued fiscal support; while Republican critics sharpened their argument that additional unemployment benefits disincentivized work.

These stories can’t all be right, but while policymaker reactions to new data remain predictable, we continue to benefit from the “reflation trade” positioning we described last month. Since then, energy stocks are up 8% and financials 6%, versus declines of 1% for the S&P 500 and 5% for the Nasdaq. We also think investors should use periods of volatility to build long-term exposure to structural winners.

In this letter, I examine three stories that we are hearing often from investors today. We believe sticking to these stories has been costing investors too much money to leave them unexamined.

1. One story is that after strong gains last year, markets don’t have much scope to move higher.
2. A second story is that our near-term focus on the reflation trade and sectors like energy and financials is not as interesting as the case for growth and technology.
3. A third is that volatility and uncertainty are rising again, so it is better to wait for both volatility and prices to move lower before engaging in markets.

In short, we believe there is still an upside story to be told.

Although global stocks are now 20% above pre-pandemic highs, a combination of strong earnings growth and reasonable valuations relative to still-low bond yields points to further upside for stocks. At a sector level, we reiterate our preference for energy and financials, for which valuations and a supportive macro backdrop point to further “catch up” potential following significant underperformance in early 2020. At a regional level, we see potential for emerging markets and Japanese equities to reverse their recent underperformance, given attractive valuations and gearing into the global economic recovery.

Finally, it remains key for investors to build a plan to put cash to work and look at how to use periods of volatility, like we have seen in recent weeks, to accelerate that plan. “Wait and see” strategies have proven costly over time, and we think that will remain the case in the medium term.

Still an upside story to be told

With global equities now up 7% year-to-date and 20% above pre-pandemic highs (with US equities up 10% and 22%, respectively), many investors are skeptical that there is much upside left.

Although additional returns may seem unlikely after such a strong rally, we think the market will remain supported by the following factors:

First, strong earnings growth. In aggregate, S&P 500 earnings for the first quarter have beaten expectations by a remarkable 24%, with profit growth set to exceed 45%. Our estimates for 2021 reflect this faster recovery, and we now expect S&P 500 earnings to expand by 40% to USD 200 per share this year, rising to USD 215 in 2022. In the Eurozone, we expect an even sharper rebound and estimate earnings growth of 50% for 2021, with a further 12% expansion in 2022. In Asia ex-Japan and emerging markets as a whole, we forecast 31% and 35% earnings growth, respectively, in USD terms this year. This pace of earnings growth has global equities trading at a price-to-earnings (P/E) ratio of 17.6x for 2022.

Second, low yields. Our year-end target for the 10-year US Treasury yield is 2%. We continue to believe that the uncertainty over whether high inflation will prove more lasting than transitory, a likely tapering discussion before year-end, and strong economic data will maintain upward pressure on US 10-year yields toward our 2% target. However, the April payrolls report has given the Fed justification to maintain its existing policy settings and defer the discussion around tapering its monthly bond purchases until later in the year. Meanwhile, Japanese and European central bank policy is set to remain accommodative. The recent rise in 10-year Bund yields is likely over, and we expect them to end the year just below zero. All this should limit how high US 10-year yields can go.

Third, the combination of strong earnings growth and low yields makes valuations seem more appealing than a simple look at a price chart would suggest, and we do not see valuations as a constraint for stocks at present. In the US, the equity risk premium (ERP, a measure of the expected excess return from stocks over investing in government bonds) is currently around 300 basis points (bps), close to its 20-year average of 333bps and above its average since 1985 of 187bps. At a global level, there is even room for ERP compression. The current ERP for the MSCI All Country World index is around 400bps, above its long-term average of 274bps.

Our base case is for the S&P 500 to hit 4,400 by year-end, for a price return of 6%. In our upside scenario, the index reaches 4,600 by year-end, for a price return of 11%. In Europe, our base case is for a 9% price return for the Euro Stoxx 50 by year-end, rising to 17% in the upside scenario. In Asia ex-Japan, our base case is for a 16% price return, rising to 27% in the upside case.

The real story is about reflation

Although we expect upside for the market as a whole, it will not be evenly distributed. I discussed last month how market outcomes will be shaped by competing narratives between “lower for longer” and the “Roaring 20s.” This has been playing out, with energy and financial stocks outperforming in recent weeks amid inflation concerns. Yet we believe the reopening trade is still not fully priced in to the market. After underperforming by 31% between the start of 2020 and the Pfizer vaccine announcement in November, cyclicals have since outperformed technology by just 11%.

The reflation trade’s potential is also borne out in valuations. Forward P/E multiples indicate that cyclical sectors such as energy, financials, and industrials are trading close to historical averages—arguably “cheap” given the reduction in long-term interest rates—while technology-heavy sectors are trading at a significant premium.

Although we do not expect the performance and valuation gap to fully close, given that the pandemic has accelerated various digital trends, we think the trade has further to run. We expect rising long-term interest rates to support the financial sector. An increase in travel and tourism, and a broader increase in mobility from in-person shopping and working, should boost energy demand and the energy sector. Meanwhile, the accelerating global economic recovery should support base metal demand in commodities.

What to do in tech?

On the flip side of the reflation trade, the technology sector has been under pressure in recent weeks. The NYSE FANG+ index, made up of the 10 most traded tech stocks in the US, is 14% shy of February’s all-time high, as fears of higher inflation and tighter monetary policy have weighed. In China, internet stocks have also suffered, as part of a sell-off that saw the broader MSCI China index dip into bear market territory.

The risk of regulatory action by Chinese authorities and weaker-than-expected share buyback announcements have been important driving factors. We expect the sector to recover in the long term, given its structural growth prospects, but think volatility is likely to persist in the short term. Global mega-cap tech stocks are trading at a forward P/E ratio of around 27x, which we don’t think is unreasonable given that we expect earnings to grow at a mid-teens percentage rate during the next three years. But with a lack of strong near-term catalysts, uncertainty about the regulatory focus globally, and potential pressure on the sector from rising yields, we also don’t see the near-term opportunity as compelling.

Against this backdrop, we advise investors to manage their exposure to global megatech, which we define as tech and tech-enabled companies of more than USD 200bn market cap. One approach is to weight overall portfolio exposure to be in line with relevant regional benchmarks. Mega-tech names account for around 18% of global equities and close to 27% of the S&P 500. We believe a mega-tech portfolio allocation in line with these proportions offers a reasonable proxy for our neutral stance on technology.

Within tech, we believe small- to mid-cap tech companies look most attractive given the segment’s recent underperformance and strong long-term outlook. We particularly recommend diversifying toward opportunities in small- to mid-cap companies that may yield “The Next Big Thing,” including those involved in themes like 5G, fintech, healthtech, and greentech. In China, we note that the internet sector is trading at a significant discount to its US peers, and focus on companies with strong balance sheets, resilient cash flows, high earnings visibility, and a managed approach to engaging in new investments. Incremental US auditing developments are unlikely to weigh significantly on Chinese tech ADRs, in our view, given their already less demanding valuations.

“Wait and see”

Volatility picked up in May in reaction to two US data developments. Consumer price inflation for April rose 4.2% year-over-year versus expectations of 3.6%, and the labor market added only 266,000 jobs for the month versus expectations of around 1 million, indicating supply constraints. This raised investor concerns that inflation will be more persistent than expected, potentially leading to higher interest rates.

In such an environment, it can be tempting for investors to wait—for volatility to abate, for a more meaningful sell-off, or for other uncertainties to resolve—before putting cash to work. Recent history marked by a series of rapid recoveries from sharp drawdowns, most notably in 4Q18 and 1Q20, has conditioned many investors to the potential gains to be had by timing market entries.

However, this story could prove costly for investors if they stick to it for too long.

1. First, although it might feel uncomfortable, the highest returns tend to come from investing when volatility is elevated, not when it is subdued. Since 1990, returns in the six months following days when the VIX index closes higher than 20 have averaged 6.7%. The comparable return following days when the VIX index closes under 20 is 5.1%. Warren Buffett’s mantra to “be greedy when others are fearful” bears out in this analysis.

1. Second, waiting for a correction has proven to be a costly strategy over time. An investor who invested USD 100 in the S&P 500 in 1960 and simply held onto their investment would now have USD 43,132. An investor who employed a “buy the dips” strategy of buying in 1960, selling at new all-time highs, and waiting for a 10% correction before buying back, would be around 80 times less wealthy, with a portfolio worth just USD 534.
2. Finally, investors waiting for risks to recede could end up being on hold for a long time, as new concerns invariably arise. Although certain events may warrant a change in strategy, we don’t believe the particular set of challenges making headlines today, including inflation fears, geopolitical risk in the Middle East, and COVID-19 variants, are yet sufficient to warrant a more cautious stance.

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Risks we’re watching

Inflation fears. The market narrative in recent weeks has been driven by inflation fears, resulting from higher-than-expected US CPI data, rising commodity and food prices, and signs of labor constraints. Inflation does not have a direct short-term impact on stocks. But higher bond yields can prompt concerns about valuations, and as such we think the bond market reaction is most important.

In our view, markets should be able to absorb higher yields provided that: 1) US 10-year yields remain below 2.25% (currently 1.66%); 2) the pace of increase remains below 75bps within three months (yields are up just 26bps since February); and 3) economic growth remains strong. We think the recent uptick in inflation will prove short-lived, given it is largely driven by factors related to the pandemic, and note that the Fed has reiterated its commitment to loose policy. Our base case is for 2% yield by year-end.

Geopolitical risk. The resurgence of Israeli-Palestinian tensions has put a spotlight on geopolitical risk in the region. As yet, despite the human tragedies created by the escalation, we do not expect the conflict to have a major impact on global financial markets. Geopolitical crises historically— from the Cuban Missile Crisis in the 1960s to 9/11—have tended to produce only a fleeting effect on global markets, as most events do not tend to leave long-lasting impacts that trigger a persistent change in economic growth. In the case of the current conflict, provided it does not draw in other Arab nations and impact crude oil supplies—a tail risk, in our view—its wider financial market implications are likely to remain minor.

COVID-19 challenges. Vaccinations continue to be rolled out at an impressive pace in Europe and North America, contributing to reductions in new infections. However, ongoing struggles to contain the virus globally risk the emergence of new variants. Yet none of the new variants identified so far appear to be sufficiently more virulent or vaccine-resistant to materially delay reopening of major economies. Furthermore, a growing body of evidence supports the efficacy of existing vaccines against the virus and its variants. Just 0.01% of fully vaccinated people in the US are known to have caught the virus, according to data from the Centers for Disease Control and Prevention. New data from Qatar shows Pfizer’s vaccine reduced infection with the South African variant by 75%, and offered 100% protection against severe disease and death.

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Investment ideas

Equities

We remain positive on the outlook for global equities in spite of the recent increase in volatility. We expect the cyclical-value trade to receive further support from the ongoing vaccine rollouts, and central banks remain committed to loose monetary policy. We keep our exposure to emerging markets because valuations look particularly appealing after the recent underperformance versus developed markets. We also upgrade Japanese equities to most preferred. Japan’s relatively slow vaccine rollout has contributed to year-to-date underperformance. However, we think that healthy earnings growth, a positive correlation to US real rates, and a high sensitivity to the global economic recovery should support Japanese stocks going forward. At a US sector level, we like energy, financials, and industrials as beneficiaries of reflation. We continue to favor small-caps versus large-caps.

Fixed income

Given tight spreads and rising government bond yields, we hold a least preferred view on investment grade (IG) bonds and prefer riskier segments of the credit universe. We like US senior loans, which we believe will be supported by the improving macro and earnings outlook, the ongoing search for yield, policy support, their floating interest rates, and moderation of default risks.

Currencies

The market has pushed expectations for Fed rate hikes further into the future, after April’s unexpectedly weak US labor market data. This supports our view for US dollar weakness and the medium-term positive trend for the euro, the British pound, the Australian dollar, and procyclical exporter currencies. The Bank of England in particular is striking a relatively hawkish note, with upgrades to growth forecasts at its April meeting and an acknowledgment that the next move in rates will be up. It also eased its pace of asset purchases and is unlikely to extend the current program, which expires at year-end. Meanwhile, the Bank of Canada announced in April that it will start tapering asset purchases, and we expect these to be reduced progressively to zero this year.

Commodities

We believe the most important drivers to support higher commodity prices are the global economic recovery and acceleration in the reopening phase. We expect broadly diversified commodity indexes to deliver mid- to high-single-digit total returns (including roll gains of more than 3%) over the next six to 12 months. At a sector level, the backdrop is most supportive of energy and base metal prices. By contrast, we expect improving global growth and higher real interest rates to weigh on gold prices.

Volatility

We think investors should use periods of elevated volatility to build long-term exposure. Investors could, for example, phase into the market by setting a monthly schedule to invest and accelerate their phasing in if the market drops further. Similar results can be achieved through structured strategies. For investors who can use options, selling out-of-the-money puts is a strategy that can generate income, while pre-committing the seller to buy the market at lower levels.

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