A win for Joe Biden in the US presidential election put an end to one of the chief uncertainties for equity markets heading into 2021, though several others remain pivotal. Control of the US Senate is still in question pending runoff elections for two Georgia seats in early January, and the pandemic’s trajectory, the global policy response, and the timing of approval and distribution of a coronavirus vaccine all could move markets in the months ahead.
Near the close of a tumultuous year in which Covid-19 delivered the most severe exogenous shock ever to hit global economies and markets, equities as a whole are nonetheless ending higher than where they started. This is thanks to swift actions by companies to shore up liquidity, along with bold responses by fiscal and monetary authorities and the development of vaccines in record time. Yet much of the equity return in 2020 has ridden on a handful of mega-cap names at the top of the indexes. This poses both risks and opportunities and points to a more stock-selection-driven market to tap potential alpha.
Broadly speaking, we view the environment heading into 2021 as very favorable for equities, for five key reasons:
A nascent improvement in equity market breadth. Equity indexes are now highly concentrated: The top 10 names account for 28% of the S&P 500 and 36% of the MSCI All Country Asia ex-Japan Index, and the ratios are even higher for certain country indexes, including India and Korea. This loss of diversification for investors may be addressed by allocating to truly active, benchmark-agnostic equity strategies. Market breadth is starting to improve as the economic recovery continues and the virus is better controlled, off a low starting point: On average, only 40% of stocks across indexes are in positive territory in 2020, despite several indexes being close to or even exceeding previous highs. The more cyclically driven and virus-affected industries are likely to exceed current modest earnings expectations after the sharp and swift cuts from earlier this year, which could propel equities higher next year.
The release of pent-up demand. 2021 promises to be a year when pent-up demand for investment in equipment, upgrades, and new technologies finally becomes visible. Companies’ management teams have now spent several years grappling with big uncertainties at the macro level, which have crimped investment decisions since at least 2018, starting with fears of a hard landing in China, the trade wars in 2019, and the pandemic in 2020. We estimate that much of industrial capacity, despite published numbers on capacity utilization, is now obsolete due to increased competition from emerging lower-cost operators that are embracing automation and digitalization. As “animal spirits” return, we believe enormous investments are needed in renewables, automation, and equipment upgrades, and capital will begin to flow again to companies that benefit from strong governance, sustainable business models, strong financials, and supportive valuations. This heralds a more stock-selection-driven market in 2021 and a move away from the narrow, “visible growth” market of 2020.
The beginning of a strong fundamental recovery. Nearly all retail categories not directly affected by social-distancing measures are up strongly, and high-frequency data are pointing to a strong fourth quarter and beyond. In the US, air cargo rates have almost doubled in recent weeks, and shipping capacity is nearly maxed out. This suggests that businesses are restocking heavily, benefiting companies up and down the supply chain. These signals are bolstered by stronger-than-expected third-quarter results, with a notable increase in operating margins. The rise in margins is largely due to savings on expenses, much of which may prove durable as companies accelerate their digitalization strategies.
China has emerged from its first-in, first-out response to the virus and is back in positive growth territory. Sales during the November 2020 online Global Shopping Festival from China’s leading e-commerce giant amounted to $74.1 billion in gross merchandise value, up 26% year-on-year. In India, the dramatic rise in coronavirus cases in recent months is coming down again, and economic activity is rebounding, with electricity consumption now up in the double-digits compared with the same period last year.
A key risk to the global recovery in the near term, however, is that the US follows Europe in terms of the spike in infection rates and must again resort to more draconian lockdowns. High-frequency data from mobility apps show that movement of people has declined quite sharply in recent weeks. We believe the equity markets would ride out a more contained rise, particularly if accompanied by more positive news on the Phase 3 trials of several vaccines in development and by further fiscal and monetary stimulus.
Concerted monetary and fiscal policy efforts to address the pandemic’s impact. Early in the pandemic, we identified three necessary elements in what might be called the Bernanke-Geithner Axiom of Economic Crisis Management from the post-2008 recovery period: 1) act fast, 2) ensure that the central bank and Treasury act in tandem, and 3) go big – with a solution that significantly exceeds the scale of the problem in order to be credible to markets. And that is what we’ve seen thus far. Total fiscal and monetary stimulus since February 2020 has reached $27.11 trillion, or 31.3% of global GDP (according to Cornerstone Macro), far exceeding the response during the global financial crisis (GFC), particularly in Europe. While some questions remain about the extent of future fiscal stimulus, strong actions by both central banks and governments will serve as a bridge to the other side of this crisis and are a key reason why we expect the “buy the dip” market sentiment we have seen to persist.
Rising earnings expectations and valuations. We believe analysts at investment banks, perhaps still raw from the post-2008 period, cut earnings estimates too hard and too soon – not only for the current lockdown-impacted year, but also out into the future, for 2021 and 2022. For example, the S&P 500 index-level estimates have been cut by nearly 30% for 2020, 17% for 2021, and 13% for 2022. We think these estimates reflect incorrect modeling of company earnings, given that the Great Lockdown Recession has no historical parallels.
In our view, an exogenous shock that occurs without a build-up of the usual recession-inducing excesses does not justify cuts in earnings expectations extending well into the future at the index level. Indeed, earnings estimates are already rising around the world. We expect this trend to continue and even accelerate as uncertainties are removed, allowing companies to plan ahead with greater confidence. As the chart below shows, we have already detected through our proprietary machine reading (using natural language processing of numerous earnings call transcripts) that top management teams of listed companies are turning positive on the outlook for their businesses. And this is happening barely six months after the low point of the recession – a very brief period compared with past recessions, most notably the GFC.
Source: PineBridge Investments based on company earnings call transcripts as of 31 October 2020.
At the same time, index-level valuations have also risen for all the major markets and are now well above their three- and 10-year medians. This is due in large part to investors’ search for returns. The approximately $15 trillion of negative-yielding debt currently outstanding and ultra-low yields in the bond markets are clearly helping to drive up equity valuations through a reduction in the implicit cost of equity in valuations.
Taken together, these signals all point to strong equity markets in 2021. Central banks are set to err on the side of caution for the foreseeable future, market breadth is improving, and earnings expectations are picking up. Moreover, we see potential for equity risk premia to fall further, given that the cost of equity is still high relative to bond yields. But despite our positive view, we add a word of caution: If central banks were to allow bond yields to rise for whatever reason, the earnings multiples applied to growth stocks in particular could quickly come under pressure, leading to a general market correction.
Differences in return across various equity markets are now less a function of their region (the “country factor” of old) and more of their composition in terms of industries and individual stocks. Decomposing each index into groups of homogenous stocks based on our Lifecycle Categorization Research (LCR) approach, for instance, shows that differences in return are largely explained by the mix of each LCR category in an index. (In a nutshell, our LCR categories segment the universe of stocks into six groups depending on their degree of sensitivity to macro cyclicality and lifecycle maturity, irrespective of their commercial or industrial activity).
The key takeaway is that for “core” portfolios managed to avoid any style bias, the alpha opportunities come from stock selection: seeking out the very best stocks to own no matter where they may be listed, and owning an optimal number of holdings to achieve style neutrality through portfolio construction. This approach opens up a large window of investment opportunities and a raft of exciting companies to own – a compelling prospect given that it’s largely through equity ownership that investors can take advantage of opportunities in a rapidly changing world, since many of these companies are debt-free or very minimally levered.
The alternative is to position for sharp style rotations through top-down allocations to various indexes, relying on the knowledge that some indexes are more cyclical than others because of their composition. The challenge with this approach is that timing style rotations is hard, particularly when markets are heavily influenced by central bank and government policy, and nimbleness is key, since beta rallies tend to be short and sharp. With this in mind, we strongly favor seeking alpha from stock selection, even in the context of the positive equity market backdrop we expect in the coming months.
Several powerful investment themes are helping frame our stock selection in 2021 and beyond:
Consumer affluence in China and India. This global theme is equivalent to a new cohort of middle-income earners the size of the entire population of the US entering the market in less than 10 years.
Technology focused on the high end and on digital platforms. Accelerated adoption of digitalization will be a lasting legacy of the pandemic, with a positive impact on the larger e-commerce platforms. Only the high-end technology providers have lasting pricing power through innovation, with swaths of providers in supply chains competing to grow or protect their market share.
The industrial investment cycle ramps up. Given the lack of conviction among top management about investing in their businesses due to macro uncertainties over the past several years, we believe considerable industrial capacity may require upgrades to achieve high levels of automation and the higher productivity needed to stay competitive.
Globally competitive companies. World-class companies are taking market share no matter where they are listed. Such companies have emerged in China and India, in particular, and are likely to execute global expansion strategies that lead to several years of high growth.
While shifts in news and sentiment will likely continue to move equity markets in the coming months, we think 2021 is poised to be an opportune time to invest in the most promising companies of today and tomorrow.
For more PineBridge views on what to expect across economies and asset classes in 2021, visit our 2021 Outlook page.
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Last updated 3 June 2021