Peak Growth, Liquidity and Valuations - What's Next?

Returns may be front-end loaded

We turn more defensive as we head into 2H21. We envisage many positive market catalysts for the US equity market are behind us, just as we are heading into a period of weak seasonality - equity markets have historically performed poorly in May-June and August-September.

The S&P 500 Index has returned 10.6% year-to-date as of late May 2021. Peak growth, peak liquidity (declining stimulus and Fed liquidity) and peak valuations (S&P 500 Index trading at 22.5x 2021 PE, a 10-year high) likely means more moderate returns for the rest of the year.

Although US GDP growth will remain above-trend for next few quarters, GDP growth will likely peak in 2Q21 at an annualized rate of ~8% (Chart 1), as tailwinds from fiscal stimulus and economic reopening begin to fade. Equites often struggle in the short term when a strong rate of economic growth first begins to slow (watch for roll-over of peak PMIs).

In the same vein, 1Q21 earnings saw tremendous growth and operating leverage on easy year-ago comparisons, and we would look for this relative strength to decline starting 2H21.

On the liquidity front, Fed is expected to announce tapering in September 2021 with tapering likely to begin in mid-2022.

Meanwhile, the proposed corporate tax rate hike will be modest earnings per share (EPS) headwind in 2022 (~7% of S&P 500 EPS assuming tax rate of 25%). In addition, capital gains tax is likely to double under Biden proposal. Past capital gain hikes have been associated with decline in equity prices and household equity allocations, albeit with short-lived impact. 

Tweaking our sector preferences

In-line with our more defensive market view, we have upgraded Healthcare to positive, Consumer Staples to neutral, and downgraded Industrials and Materials to neutral (while remaining positive on Gold miners). 

Remain positive on the US equity markets

Taking a step back from tactical positioning, we remain overall positive on the equity markets. We are only a year from the trough of the recession and probably still early in this new bull market. While there is potential for episodes of volatility, this would create opportunity, with the market likely to make higher highs next year.

Positive on Healthcare sector

We turn more positive on the US healthcare sector given its defensive and quality attributes, decent earnings growth, and undemanding valuations. Moreover, while Healthcare has held up relatively well against the pandemic backdrop, the sector has lagged in terms of market performance and represents a catch-up trade.

Valuation and modest earnings growth

The broader sector trades at a steep discount relative to the S&P 500 (Chart 2) and on favorable valuations in comparison to other sectors (Chart 3). While the sector may not offer the same earnings growth expectations as cyclicals or technology, healthcare does compare favorably with other non-cyclical sectors (Chart 4), having benefited from pandemic cost cutting to drive margins.

 Post-Covid growth opportunities

Consumer attention to personal health and wellness was amplified in 2020 due to Covid-19, leading to changes in purchasing patterns and health regimes. We can expect “wellness” to remain at the forefront of attitudes and behaviours and when combined with shifts in expectations around how care is offered and experienced, new value streams are likely to emerge.

At the same time, the Covid-19 vaccine market is huge and is likely to remain with the occurrence of new variants and the needs of different demographics driving demand. A key Covid-19 vaccine manufacturer in the US, for example, is developing new formulations and said it expects durable demand for its Covid-19 vaccine over time, similar to that of flu vaccines.

Diagnostic delays caused by lockdown measures and changes to patient behavior could also result in a pick-up in spending.

The potential for “less severe” political risk

Lowering drug prices continues to be a bipartisan issue as both parties aim for more affordable medical care for Americans. Although this remains a key consideration for pharmaceutical names, more pressing issues in the political agenda may well delay or divert attention.

The “bark worse than the bite” argument for a Biden presidency is one that could apply to healthcare, particularly as Medicare For All is no longer a policy initiative. And despite the introduction of the Affordable Cares Act (ACA), the Obama Administration, for example, did not lead to massive, painful reforms that hurt sector stocks. Perhaps political risk has been excessively discounted by the market.

How to play the sector

Although it is a sector with low sensitivity to key market themes of capital expenditure, GDP recovery, interest rates and inflation, healthcare can offer different dynamics to enhance client portfolios:

• Defensive exposure with reasonably priced growth characteristics within the pharmaceuticals space, often offering healthy dividends and valuation attractions.
• Covid-19 conditions, supporting vaccine providers, distribution names and diagnostic companies that should continue to benefit from the sales of coronavirus tests.
• The “reopening trade”, notably through medical device and health insurance names that should benefit as elective procedure volumes recover to pre-pandemic levels and there is a stabilization in insurance claims.
• Long-term structural growth based on increasing global demand for cost-effective value-based health care, aging populations, and rising R&D outlays, have resulted in a steady flow of innovative products and revenue growth, supporting names in biotech, digital health and exposure to rare diseases. 

Inflationary pressures in focus

Inflation has dominated market headlines over the past several weeks with investor anxiety reaching a crescendo as US April 2021 headline CPI (consumer price index) jumped 4.2% year-on-year in April, the largest uptick since 2008, while PPI (producer price index) for final demand goods increased 6.2%. 

While inflation worries have clearly spooked investors, we do not anticipate the recent surge will translate into a prolonged period of elevated inflation.  The April CPI print had an easy year-on-year comparison due to the pandemic. We expect pandemic distortions to inflation data may peak over April/May 2021, and high readings would ease off gradually into year-end.

So far, inflationary pressures have not impacted margins - net margins for S&P 500 (ex-Financials) jumped to record highs in 1Q21. Nonetheless, companies are clearly discussing rising costs (from materials, to transportation to labor) and therefore it warrants continued monitoring in the coming months. For instance, mentions of “inflation” during earnings calls have been prolific with 175 S&P 500 companies citing the term in 1Q21, the highest tally going back 10 years.

Wage inflation is of particular concern, given its stickiness, and will be more of a problem for labor intensive sectors (Chart 5), especially those who cannot pass the costs onto consumers. On the other hand, retailers with more revenue exposure to low income consumers may see some benefits from gains in real wages.

In the near term, the mismatch between supply and demand should drive wages higher despite meaningful slack in the labor market as a whole, driven by bottlenecks and labor shortages from the reopening process. Against the surge of labor demand, labor supply has been slow to catch up. Various factors appears to be at play including health concerns, childcare issues, and disincentive to work due to expanded unemployment beneficiaries. 

We remain optimistic that the current labor shortage would sort itself out as we progress through the year, as growth normalises to more sustainable levels, and more workers return to the work force as health concerns subside and generous unemployment benefits expire by September. 

Thoughts on the Growth vs. Value, and the Tech sector

With regards to the growth vs value trade, growth stocks have underperformed value stocks by a large margin since late April 2021 (Chart 6). With the US Treasury 10 year yield stabilizing near term at the 1.6% level, we see opportunity for a tactical rebound in growth and technology stocks.  This is within context of our Neutral view on the Technology sector, while keeping a watchful eye on deteriorating market breadth within the Nasdaq Composite Index (Chart 7). Overall, we don’t think the Growth to Value rotation has run its course. Nonetheless, should inflationary pressures ease as we move through the year, it would be supportive of relative performance of the Tech sector against the broad market.

Tech megacaps reported excellent 1Q21 results, beating expectations on both top and bottom-lines, though post-results performance was mixed.  Overall, while we think the Tech megacaps as a group will unlikely outperform the S&P 500 Index in the near term (Chart 8) (on higher rates, growth to value rotation, decelerating growth on high base comparison), but with reasonable valuations and structural growth drivers intact, this period of lacklusture performance will be a good opportunity to accumulate these high quality names.

What about Semiconductors?

Semiconductor stocks have seen a correction of late, with the SOX Index underperforming the S&P 500 Index by ~14% since the beginning of April.  On an absolute basis, the SOX Index corrected ~14% peak to trough as the S&P 500 index stayed rather flat during this time.

We suspect what triggered this was a correction in ISM manufacturing PMI off peak level of 64.7 in March (to 60.7 in April) (Chart 9). Investors are also concerned about the cycle peaking (1H21 semi sales being past easiest year-on-year compares), double-ordering amidst semiconductor shortage creating excess inventory down the road, while valuations have rerated substantially.

We remain positive on semiconductor and semiconductor equipment stocks, and are buyers on dips, as we expect to see continued positive earnings revisions through 2021. Global semiconductor demand continues to expand and supply-side dynamics remain tight, resulting in the demand/supply gap continuing to widen.

In the just-completed 1Q21 earnings season, we saw Calendar Year 2021 consensus EPS estimates for the group revised higher by ~9%, and vast majority of our coverage reported a revenue/EPS beat on the reported quarter as well as on the 2Q outlooks. This is reflective of strong demand trends and tight supply dynamics across almost every end market in semis (automotive, industrial, cloud computing/networking/storage, consumer and gaming).

Despite near-term concerns on “peaking fundamentals”, we see continued positive EPS revisions for the next several quarters on strong demand and pricing power amid a tight supply environment—we believe semi companies are shipping 15-40% below current demand levels, and it will take at least three to four quarters for supply/capacity to catch up with demand and then another one to two quarters for inventories at customers/distribution channels to be replenished back to normal levels.

We also note that typically, the cyclical downturns in semiconductors are demand driven. Supply side dynamics (like double ordering) potentially exacerbate the magnitude of downturns but they typically are not the catalysts for past cyclical downturns. On the whole, we think the semiconductor industry is probably only halfway through the current up-cycle (the last up-cycle was 9-10 quarters long).

After a sharp bounce since mid-May, in terms of valuation, the SOX Index is now trading at 22x forward P/E, against its 3-year average of 17.5x (Chart 10). Meanwhile, SOX Index valuation is trading in-line against the S&P 500 Index, against a historical discount (Chart 11). However, if we compare semis to industrials, semis are trading at ~20% discount on PE basis, despite much better profitability, free cashflow, sales growth, and structural growth drivers.