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Political risk on both sides of Atlantic adds to uncertainty
- Democrats have higher chances to occupy both the White House and the Senate. We prefer to underweight US big tech companies due to the risk of additional regulation. A tax hike could cut around 9% from 2021 S&P 500 earnings, with utilities, energy and communication services likely to be the most affected, but increased fiscal spend would offset.
- Sentiment and liquidity indicators are the ones that should support stocks and balance rich valuations. Professional investors remain under invested, despite the easiest financial conditions in 20 years, and record IPOs
- We also prefer International (ex-US) stocks, value stocks, and small and mid capitalisation stocks, cyclical sectors as materials and industrials. These are geared towards global GDP growth, Chinese stimulus and weaker USD.
In Q3, despite the September correction across major stocks markets, the global markets measured by the MSCI World Index gained 8.0 per cent. In the US, the S&P 500 led by 11.2 per cent gains, while the Nasdaq added 8.9 per cent. By contrast, the Euro Stoxx 50 finished Q3 negative, down -0.7 per cent. UK stocks have been burdened by Brexit negotiations and fell by -4.0 per cent. Among sectors, technology, consumer discretionary, materials, and industrials added 12.0, 15.3, 13.4, and 12.5 per cent. On the opposite side of the performance spectrum, energy stocks lost striking -19.6 per cent in the US and -17.6 per cent in Europe. Emerging markets were strong, adding 9.7 per cent and led by Chinese and Indian stocks.
The previous quarter was particularly uncertain from the start. Q2 earnings season had brought much better than feared results, though the outcome was still very negative given the steep decline in economic activity due to the pandemic. Analysts missed earnings by a record margin, with actual earnings 22.2 per cent better than expected. The highest positive surprise came from consumer discretionary, industrials, and health care sectors. Only real estate and energy delivered a negative surprise. However, actual earnings for S&P 500 companies nonetheless contracted by a historical record of -29.7 per cent. Positive earnings growth was shown by utilities, health care, and technology. The worst performing sectors by growth were consumer discretionary, industrials, and energy.
The current Q3 earnings season will likely remain challenging to forecast. According to FactSet, 52 percent of those S&P 500 companies that have historically provided annual earnings guidance either are not providing or withdrew a previous guidance for 2020 and/or 2021. Almost all these companies refer to the uncertainty of the future economic impact of the pandemic as the main underlying reason. As of 12 October 2020, the S&P 500 is forecasted to show a decline in earnings of – 20.5 per cent. The record positive surprise in earnings for Q2 can be attributed to the low analysts’ expectations, and despite recent earnings upgrades in the US (but not in Europe)we believe the bar may still be too low for the upcoming earnings season.
The main risks in the near term stem from US politics and from the pandemic response. According to a survey conducted by Citi, 47 per cent of respondents consider the US Election as the main factor driving equity risk near term, while a Covid-19 vaccine and US Fiscal stimulus resolution were put forward by 23 per cent and 20 per cent respectively as the main concerns. Overall, US politics is considered as the most important driver by 67 per cent of the survey participants. After Donald Trump and Joe Biden took part in the first US presidential debate of the campaign, the gap between candidates widened to more than 10 per cent. As a result, polls and betting markets increasingly suggest that the Democrats are favoured retake the Senate and the White House. In this scenario, there are at least two consequences for the stocks.
The first is taxes. One of the most novel aspects of Biden’s tax plan is the introduction of a “book tax”, a 15 per cent minimum tax on corporations with more than USD 100 million of earnings. According to Morgan Stanley, the full implementation of the tax plan will likely result in a 9 per cent decrease in 2021 consensus earnings for the S&P 500. Utilities, energy, and communication services are the most exposed sectors.
The second consequence of a “blue wave” could be increased antitrust activity targeting US big technology companies. Such companies as Google, Facebook, Apple, Amazon are dominant players in their respective markets. While all of them arrived at the current market shares largely by offering superior products to their customers, they are under increased scrutiny. We do not expect breakups will be considered under our base case scenario, and instead expect further regulation and increased taxation. Overall, we are cautious about investments in vulnerable sectors to increased taxation and regulation, especially when added to rich valuations.
In the US, Republicans and Democrats have yet failed to reach an agreement over the new fiscal stimulus deal. The deal was already delayed several times, and time is running out to get the deal through before the presidential election . While we are confident that an agreement will be eventually be reached, the delay further burdens the disposable income of US consumers. Thus, we are also cautious about the US Consumer Discretionary sector, which is the third-largest in the US market.
Turning to the risk factor which is considered by Citi respondents as the second most important, a Covid vaccine, the race appears to be entering the final mile. With USD 10 billion having been dedicated for the research and the 7 leading vaccine candidates now in their phase 3 trials, we expect the vaccine to become available sooner rather than later. According to the Good Judgment Project, the most likely scenario is that a vaccine will become widely available in Q1 2020. However, this may prove too late for many companies in industries affected.
The recovery path remains uncertain. Boeing did not get a single new order in September, and Cineworld, the largest UK cinema chain, has closed all of their sites in the US, UK, and Ireland until 2021. This illustrates the obstacles facing the most impacted firms. For those companies lacking strength in balance sheet to endure, investors are effectively making bets not only on the recovery itself but also on its timing. We think that it is still not prudent to try and time the recovery and would recommend making only conservative bets on the eventual resolution of the pandemic via companies with conservative financials and historically high margins.
As already mentioned, Energy stocks did particularly poorly in Q3, and the backdrop for both demand and supply remain challenging. US shale oil producers, which are considered marginal producers, are being kept afloat by cheap/free money while continuing to pump oil and thus keep excess production capacity on the market. Meanwhile, Saudi oil production is steady despite a fall in oil prices, and thus OPEC+ is also failing to balance the market.. On the demand side, the International Energy Agency cut its forecast several times in recent months for global oil demand for 2020, and warns of an “even more fragile outlook”. Moreover, air travel data remains weak with a recovery of air traffic volumes to pre-pandemic now expected to take several years. The International Air Transport Association (IATA) downgraded its traffic forecast for 2020 to reflect a weaker-than-expected recovery, and IATA now expects full-year 2020 traffic to be down -66 per cent .
In contrast to oil, we see a better supply and demand pictures for Materials. Activity in Materials has been less affected by the global pandemic compared to industries directly engaged in providing face to face services. It is easier and cheaper to organize safe production in a factory or mine than in an office or retail establishment. As such, production volumes were not as substantially affected. Even more important, the demand for goods has remained robust, while demand for services remains severely diminished. In addition prices for many commodities have been supported by the weaker USD, monetary support from central banks, and Chinese stimulus. The latter includes fiscal stimulus of more than 5 per cent of GDP and monetary support of more than 30 per cent of GDP in a form of social financing.
Over the course of the quarter, we have also seen a further escalation of US/China tensions. The US President signed an executive order addressing the threat to American’s personal and propriety information. The measures threaten penalties on any US resident or company who transacts with TikTok, WeChat (Tencent), and most recently Ant Financial (Alibaba). Nonetheless, in our global multi-asset portfolios we are currently maintaining our holdings of Chinese IT companies that are primarily focused on the domestic market as we do not expect their operations significantly impacted.
On the Brexit front, the House of Commons approved the UK Internal Market Bill which some argue is a breach of international law. The EU in turn started legal action against the UK for breaching the terms of the Withdrawal Agreement. With the process at risk of ending up in the European Court of Justice, a chaotic UK exit is possible though negotiations continue. These developments make GBP moves far less predictable and are a risk for UK investments. On the other hand, with the FTSE 100 traded at a 14.7 price-to-earnings ratio, valuations for UK stocks are much more appealing compared to other developed markets. Overall, we prefer to avoid the UK listed stocks until there is more clarity with Brexit.
After the summer rally across almost all stock markets, valuation metrics are flagging that global equities are expensive. The 12-month forward price-to-earnings ratios for the S&P 500 and the Euro Stoxx 50 are 22 and 19 relative to average values of 15 and 12, respectively. The constant decline of interest rates seen over the last decade has favoured assets with longer de facto maturity, like growth stocks. This decline in rates created a strong tailwind for growth (such as NASDAQ/IT) stocks and a headwind for Value and cyclicals (such as materials/industrials), but with rates near the zero bound it is hard to see future declines and thus further valuation expansion. The rally left the valuation for growth stocks especially rich. The price-to-earnings ratio for the NASDAQ looks especially stretched at 32 (vs the 10-year average). With interest rates in almost all hard currencies already near the lower bound, we expect a rotation away from Growth stocks (including US big tech stocks) to the broader market.
Sentiment and liquidity should support the broader market and somewhat offset rich valuations. According to the American Association of Individual Investors as of 9 October, there were 26.4 per cent fewer bulls relative to bears compared to the average value for the last 6 years. Professional investors remain under-invested, which in turn makes a buy-on-dip strategy more likely. On top of that, liquidity conditions remain extremely accommodative. In the US, the Financial Condition Index from Goldman Sachs points to the easiest financial conditions in 20 years. This cheap money was not unnoticed by companies which have used this opportunity to raise funds via stock offerings. According to FactSet, US companies managed to raise almost $65 billion of gross proceeds from 178 IPOs over the course of the quarter. This is the highest quarterly number in a decade.
Overall, we expect that Q4 will be more challenging than Q3 as political risk on both sides of the Atlantic adds to the uncertain Q3 earnings season and rich stock valuations. Among our core equity holdings, we prefer a tactical rotation from Growth/US stocks towards International/Value/Cyclical stocks. With Biden and the Democrats having improved odds of occupying both the White House and the Senate, we see a risk of additional regulation of US big tech companies and prefer to underweight the sector. The proposed Biden tax hike could cut around 9% of 2021 S&P 500 earnings with Utilities, Energy, and Communication Services likely get the hardest hit. Among international stocks, we prefer Cyclical sectors such as Materials and Industrials which are geared towards Chinese stimulus and a weaker USD. Until we have clarity over the execution of Brexit, we prefer to avoid UK stocks. The energy space looks challenging to us as the supply-side has failed to rationalise in the face of increasingly weak demand. The economic recovery remains patchy and partial, and with the timing of an end to the pandemic uncertain our focus remains on companies with strong balance sheets that will allow them to survive the impact of new virus outbreaks until the vaccine arrives.
Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.
If not otherwise indicated, all graphs are sourced from Dolfin research, October 2020.
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