Investment Outlook - Market Update
Global equity markets again delivered strong returns during the third quarter following on from the extremely strong returns of the second quarter. Strong index returns since the lows of March mask the real story, which is the extraordinary returns from a handful of technology stocks. Remarkably, five stocks – Apple, Microsoft, Amazon, Facebook and Alphabet/Google now account for almost a quarter of the market value of the S&P 500*.
As Covid infections remain a global headline issue, global monetary and fiscal support remain to the forefront. Cheap and available liquidity found its way more into Growth-oriented ‘Stay at home beneficiaries’, be they technology, consumer staples or indeed healthcare stocks, while on the other side more Value-oriented ‘Return to office’ stocks and industries such as restaurants, airlines, hotels and financials remained out of favour. By the end of the quarter this discrepancy between Growth and Value had extended to unprecedented historic levels. The good news is that the global economy itself grew strongly during the quarter from the lows of a negative second quarter. This better fundamental news was generally ignored by markets.
Our baseline scenario for the final quarter of this extraordinary year of 2020 is that equity markets are likely to make little further progress. I expect a continued moderate pick-up in economic growth globally and do not expect a double-dip recession. There are heightened expectations that it could indeed be more of a roller-coaster with the expected drama of the US election and any follow-on, as well as the persistent challenges of Covid second phase eruptions.
Looking beyond such events there are reasons to be more confident as we look ahead to 2021. In an environment where confidence improves and the macro and earnings growth outlook becomes more apparent, combined with distribution of a Covid vaccine, there is the potential for 2021 to be the opposite of 2020, where stocks ‘re-connect’ again with fundamentals. While global monetary and fiscal support will remain as a backstop, they are not the driver of returns as was the case in 2020. Such a scenario provides the stage for a large rotation within equity markets as we return towards a more ‘normal’ global economy and stock markets.
Asset class outlook:
As an asset class, equity markets in aggregate now appear expensive on both a trailing and forward P/E basis. As discussed, Equities, particularly in the US, are dominated by a very small number of extremely expensive mega-cap names particularly but not solely from the technology sector. At KBI we have very little if any exposure to such names, but do highlight that for index investors these stocks are now dominant.
The upcoming Q3 reporting season is expected to again see headline reported earnings decline relative to a year ago, but to deliver a meaningful improvement from the lows of the second quarter. The results themselves and in particular commentary and outlook from management teams could well influence stock market direction.
We continue to highlight that we are at the beginning of a new economic cycle . As such, for many more value or cyclical-oriented stocks and industries which do not look particularly cheap on 2020 or even 2021 earnings, they have room to grow as the next cycle develops out into 2022/23 and beyond. For long-term investors we are at extremes of valuation within equity markets and at a point where value and cyclicality should prevail over growth and defensiveness . Regionally, such an environment can also present Emerging Markets and Europe with a more favourable outlook I believe.
Fundamentally, government bonds remain extremely overvalued at the current negative yield levels. Bond markets are in many ways priced ‘artificially’ and not reflecting their true fundamental value. That said, the current regime of massive government bond buying is likely to anchor yields around current levels, irrespective of what may be otherwise dictated by fundamentals coupled with massive increases in debt levels. Corporate debt as an asset class will face some challenges of corporate defaults.
Longer-term, with renewed global economic growth we believe bond markets are vulnerable to a significant sell-off given the outlook for massive new supply of debt by governments and again the possibility of renewed inflation concerns at some point.
*Source: S&P 500, as at 30th September 2020