Jan 8, 2021 | Articles, Global Markets Update
January Market View
Equity Market Recovery – Historical Context
The very optimistic November market sentiment carried over to December. Again, all risk assets recorded robust gains, albeit at a lower rate than the previous month. The big question now is whether the strong momentum shown in the last two months can carry over into the New Year.
“Unprecedented” is a word often used about the COVID crisis and certainly most of us have never experienced a similar situation. While it is also an unprecedented situation for the financial markets, broad equity index performances have certainly experienced a similar backdrop. In the last 50 years we have seen a similar rate of recovery from market lows three times – from September 1974, July 1982, and of course from February 2009 during the GFC. It is interesting to note that in these three periods, and indeed for the recovery of all seven previous drawdowns in the last 50 years of greater than 20%, that there appears a significant resistance level after the MSCI World Index approaches 40-50% recovery. Ominously, we are about there now in this recovery.
Source: Bloomberg, Odyssey
As market veterans realise, every situation is slightly different, and this time may end up reacting very different than history. However, markets also do tend to repeat themselves in a broad sense. At the end of the day, none of us have a crystal ball, so we advise investors not to get caught up with the hype and stay disciplined with their risk allocations and investment decisions.
The short-term question is what the January performance will look like and whether that is a harbinger for 2021 performance. While there is plenty of statistical evidence for “Sell in May and Go Away” until November, the evidence for January is less clear cut. In the last 50 years, the proportion of times both January and the full year return was positive is just 54%. You don’t need to run the stats on that to realize the two are not correlated. The proportion of times that January is positive is 64%, again hardly something to get excited about. Compare that to the 78% of years where the month of December is positive.
Why is the Equity Market so Much Higher than pre-COVID?
The simple answer is valuation multiple expansion. Optimists may say that valuation multiples should be high at the bottom of the economic cycle and low at the top. This phenomenon can be seen in many cyclical industries. However, for the market as a whole, there is little empirical evidence for this. The only time we have seen forward PER estimates this high was during the Dotcom boom and that was a speculative rally. Under this scenario, stock prices rise if the gain in EPS is higher than the fall in the EPS multiple. How does the maths stack up when looking at the S&P500 and consensus EPS forecasts? The S&P500 is trading on a next year (2022) forward PE multiple of 19.5x. This is 32% higher than the 13.3x multiple in 2010-2015 period in the years when the market was climbing out of the GFC when we also had zero interest rates. The market is expecting earnings growth to slow in 2022. If we assume this as peak cycle, we would expect the forward PE ratio to fall at least back towards the average of 13.3x, if not below. This means 2022 EPS expectations need to be 42% higher than 2020 level and 22% higher than the very strong 2019 level in order for the market to merely stay flat. This appears a tough ask.
However, should the market believe a higher market multiple is justifiable for longer, then the reliance on EPS growth is lower. This situation may play out should the recovery appear strong in 2021, providing the expectation strong growth will remain for 2022. Periods of high valuations can persist, as they did in the late 1990s, and while they have historically always reverted to mean, the timing is difficult to predict.
Source: Bloomberg
Diminishing Choices
Since the trough of the equity market in March 2020, the MSCI World Total Return Index has surged by a staggering 70%. However, despite positive inflows in November after the US elections, US equity has experienced fund outflows in a trend that has persisted since 2015. In the liquid space the main beneficiary has been credit and in the illiquid space, while transactions have slowed significantly, the growing popularity of private equity, credit and real estate appears undiminished.
The positive takeaway from this for equity markets is that it appears investors are underweight equity, and its most liquid rival for fund flow, bonds, is providing a historically low yield. The Bloomberg Barclays Global Credit Index is currently yielding 1.4%. It is doubtful many investors, private or institutional, would be satisfied with that return, even for a relatively “safe” asset class.
Performances
December Returns
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Dec 17, 2020 | Articles, Global Markets Update
December Market View
Christmas Cheer
Last month was the best November on record for many major Equity Indices. The MSCI World Index was up 12.2%, even higher than the S&P 500 index, with Europe leading the charge. The MSCI Europe Index jumped 13.8%. Credit and commodities, particularly oil, joined in the festive atmosphere as risk assets rose on the back of positive vaccine news as well as the dissipation of US election concern.
The anticipated massive roll-out of COVID vaccines expected in H1 2021 has resulted in cyclical stocks being in the ascendency during the month, despite mixed reports on new COVID cases. The MSCI European Bank Index surged 31% and the European Energy Index rise was even higher at 33%. Industrials gained 14% and even InfoTech climbed 15%. The US story was similar. The momentum has so far continued into December.
Source: Bloomberg
2021 – A Year of Normalisation
Some say the world will never be quite the same after COVID. Certainly, the gains in technology adoption, particularly those that facilitate a stay-at-home lifestyle, is not likely to regress. However, current growth rates are not likely sustainable and as people return to a semblance of pre-COVID lifestyles, cyclical stocks are likely to be greater beneficiaries. As an example of the potential pent-up demand for pre-COVID goods and services, US commercial bank deposits has now grown by USD2.5tn since the end of February 2020. Despite the higher unemployment rate, there is clearly a large swathe of money that could be used on consumption as lockdown restrictions ease. Europe has experienced a similar phenomenon where household bank deposits grew by EUR401bn from Feb – Oct, almost twice the level of the corresponding period in 2019.
Source: FRED
Can Equity Markets Go Higher?
The MSCI World TR Index has gained a staggering 67% since the nadir on March 23. It is now 10% above the pre-COVID peak and up 14% YTD. With nominal GDP in major economies not expected to regain 2019 levels until at least H2 2021, it is valid to question whether the market has run ahead of itself. After-all, even with a then unprecedented stimulus, the Index took a full six years to regain its pre-GFC peak. For COVID it took less than six months. However, the cause of each crisis was vastly different. The GFC was an issue of acute overleverage at the consumer level. Following the GFC it took almost 5 years for US households to recover their net worth. While there is only data to April 2020, it appears there was only a momentary disruption to household net worth due to COVID before a full recovery. With the subsequent rise in equity markets, in addition to house prices rising 2.6% from March to September 2020, we can assume US household net worth is currently higher than pre-COVID.
Source: FRED
While equity gains in the last 6 months are unlikely to be repeated in 2021, there does not appear to be any structural impediments to equity markets going higher as long as economies do start to normalize in a manner that is not materially different from expectations. We would not be surprised of a few bumps in the equity markets over the transition period in the next 1-3 months, but we remain constructive over the medium to long term due to the low interest rate and heavy fiscal stimulus environment.
Financials, Mid-Small caps, Europe and Asia are Popular Bets
There are several popular themes for 2021 and they are generally recovery focused. In short, those that suffered the most during COVID are expected to benefit the most in the recovery. This includes cyclical stocks, mid-caps or small-caps, due to leverage to the local economy, Europe, where corporates have been decimated by the lockdowns, and Asia, where the earnings growth appears to be highest.
Source: UBS, JPMorgan, Morgan Stanley
What to do with FAANMG?
Many equity investors still have material holdings in these stocks. Despite their preference for other stocks, sell-side strategists and analysts are hardly infallible and often look at the shorter term. Valuations for some of these stocks are well-within their historical range (Facebook and Amazon) and with low interest rates, it is difficult to argue they are expensive. I would not necessarily be a seller of any of these stocks for long term investors as long as the rest of the equity portfolio is well-diversified and position sizes are not excessive. However, admittedly, the upside for other sectors appears potentially higher.
The Case for Using Fund Managers
It’s been a great ride for a decade or more with FAANMG. The same goes for Tencent and Alibaba. However, the downside of an easy ride is that many investors may not be used to the difficult slog of seeking new investment ideas, monitoring a wide range of stocks, and being tactical and dynamic with asset allocation. Some investors may be happy to ride through poorer relative performance periods, content with a longer-term view. For those that want to work their money a little harder every year, allocating a portion of their equity investment to active fund managers whose job is to be concerned with relative performance may be an alternative. Another benefit is that mutual fund managers won’t hold significant amounts of cash so that if you are positive on the equity market in 2021, you will not be tempted to sell stocks during periods of volatility because some stocks have fallen precariously, and miss re-investing should it bounce back up quickly, i.e. the investment is more strategic and because it is diversified it will likely fall less than single stocks.
Performances
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Nov 16, 2020 | Articles, Global Markets Update
November Market View
In God we Trust
It appeared there was 2 main factors driving the market on US election day. The first was simply the relief that the event was finally taking place after a nervous S&P 500 had fallen 8% in the prior 3 weeks. The second was a little more perplexing. As the polls see-sawed from favouring one candidate to the other, the market kept going up. The one constant was that it was a close race, i.e. neither party was going to control both houses. This can be interpreted as neither candidate being particularly appealing to the market, and the likely difficulty in carrying out ideological policy was regarded as a positive.
The market is expecting that the highest priority of the government post-election is to get the stimulus bill passed. Jerome Powell has recently reiterated that the country requires “direct fiscal support”. Assuming the departing President actually departs, and the bill is passed, the remaining gorilla in the room is COVID.
Hallelujah
Pfizer and BionTech announced on November 10 that in phase 3 trials their vaccine was more than 90% effective in preventing COVID-19 in participants without evidence of prior infection. Submission for emergency FDA approval is planned soon after the safety milestone is achieved, which is expected in the third week of November. The partnership projects producing up to 50 million vaccine doses in 2020 and up to 1.3 bn doses in 2021.
At a time when the second wave continues to spread rapidly across the US and Europe, this is indeed welcomed news. Other Western firms also in phase 3 trials that have yet to report are Moderna, Johnson & Johnson, and AstraZeneca & University of Oxford. All these firms have received funding from the US government to develop and distribute a COVID vaccine.
Chart 2: New COVID cases in the US and Select Countries
Source: Johns Hopkins University
Return of the Prodigal Son
The two most shunned sectors in the last 7 months have been the US Banks and Energy. While the oil price is a complicated issue, the banks have historically been a favoured sector to benefit from recessionary conditions. However, due to unique aspects of the COVID induced recession and the resultant low and flat interest rate yield curve, the Banks have had little succour from investors … until now.
Source: Bloomberg
Prior to the Pfizer & BionTech success, the US Banks sector were down 34% YTD. On the announcement the sector gained 13%. Other downtrodden sectors such as those in the travel industry companies surged, with Cruise Ships rising 27-28% and the Global JETS (airlines) ETF jumped 18%.
At the same time, stocks that had benefitted most from COVID, such as many in the Tech sector fell heavily as investors sold momentum and bought value. Given the 66% difference in performance between the InfoTech and Bank sectors YTD prior to the announcement, this was understandable. The Banks sector still needs to rise 75% to catch up to the InfoTech YTD performance, and we expect this performance gap has more room to narrow. Indeed, the more diversified portfolio we have been calling for over the last two months seems even more applicable.
Short Market Comment
October was a month of two halves, with equity markets surging up in the first half, only to give up those gains up and more as the election and surging COVID cases cast a pall over the markets. The MSCI World Index fell -2.5%. US Tech stocks continued to their losses after a difficult September, while US banks started to outperform, in a trend that has accelerated into November. WTI Oil also fell 11% while credit markets and Gold were relatively resilient.
Horizon Portfolio Performance
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