- Buoyant US Q4 ‘20 earnings season: US companies having reported so far (around 40% of the S&P 500) are beating their forecast in 84% of cases (well above the 74% average). An important support for equities.
- Market volatility declines: VIX stock market volatility fell back to under 23 by 3 February, after jumping to 37 in late January. This reflects the unprecedented volumes in call option buying by US retail investors, a new development.
- Bubble worries: mini bubbles have appeared in many areas of markets, fuelled by surging retail investor volumes. This could be the prelude to a near-term market correction. We would use any correction as a buying opportunity in stocks.
- Small-caps lead in January: the Russell 2000 index (US small companies) recorded +5% in January against -1% for the S&P 500 (US large companies). We like US, EU small caps.
- Cyclicals continue to lead defensive sectors: most cyclical sectors have registered double-digit gains over the last 3 months whereas consumer staples are a significant laggard. We like cyclicals.
- ESG Focus – Clean Energy: Clean energy indices continue to perform very well, buoyed by expected US and EU renewable infrastructure investment. Fund flows continue to favour ESG funds including renewable energy funds.
Global Equities view
Positive fundamentals, but bubble risk
Fundraising mania in January: According to Refinitiv, companies have raised as much as USD 400 billion from issuing fresh bonds (USD 337bn) and equity (USD 64bn) in just the first three weeks of January. This is roughly USD 170bn above the average for this time of the year.
Rising stock market valuations and easy liquidity conditions have been potent catalysts for fundraising by companies, together with record-low corporate bond yields (4.2% on average for US high yield bonds at 26 January).
Combined with the emergence of mini bubbles in a number of areas of financial markets, including hydrogen stocks, cryptocurrencies and SPACs (Special Purpose Acquisition Companies) over the last few months, this does suggest a heightened level of risk for equity investors today.
US caution: for this reason, we remain Neutral on the US stock market, given its elevated valuation and overexposure to the technology sector.
US and UK Covid new cases are falling: while there has been much focus on the acceleration in Covid-19 vaccinations in the US and UK, and the relatively slow start to vaccination programmes in Continental Europe, note that new Covid-19 cases are already falling rapidly in the US and UK – indeed, new case rates have been falling since 12 January.
The positive impact from vaccinations should accelerate this autumn in new cases over the next few months, allowing for a progressive re-opening of the consumer economy.
US leading economic indicator accelerates: the weekly ECRI US leading economic indicator continues to accelerate, underlining the positive momentum that should carry over into positive Q4 earnings announcements and positive guidance for 2021. This remains a potent driver of stock market momentum, together with long-term real interest rates.
Our medium-term equity market view remains resolutely positive, with the potential for double-digit gains over 2021. However, in the very short term, sentiment and fund flows appear somewhat over exuberant, suggesting the risk of a small market correction. We look to accumulate equities on any market dips, as the undiminished global liquidity flows combined with historically low real yields and rebounding earnings momentum should remain a bullish cocktail for stocks over this year.
Q4 earnings season
Very strong releases in the US
The Q4 2020 earnings season has started very strongly: US companies having reported so far (around 40% of the S&P 500) are beating their forecast in 84% of cases (well above the 74% average).
US earnings have so far surprised by 13.6% on average above expectations (somewhat boosted however by some positive ‘exceptionals’ for financials such as a decrease in provisioning); it is well above the 5-year average of 6.3%. If this trend holds it would be the fourth-largest earnings percentage surprise since 2008.
With this trend, the 4th quarter could show year-on-year positive earnings growth in the US. This would be an impressive achievement given the covid pandemic context.
Companies are now providing guidance for 2021 whereas up until recently, many did not dare to give any outlook. Earnings expectations have continuously been revised upward (see chart).
Positive revisions also in Europe but fading
We have also seen plentiful positive earnings revisions in Europe. However, with the Covid-19 resurgence in some countries, new strains, and slow rate of vaccination, earnings revisions are somewhat losing momentum.
In Europe, after robust upward earnings revisions of late, 2021 earnings per share (EPS) expectations are now 5% below 2019 EPS. Latest improvements have been seen mainly in Materials, Energy and Autos.
Consensus EPS expectations for 2022 are now 11% above 2019 EPS.
We are still in the early stages of the Q4 reporting season in Europe but there have been plentiful positive earnings surprises in various sectors. Several European tech results have been impressive.
But there is nervousness relating to the Covid-19 new strains, particularly the UK and the South-African variants. This is weighing on confidence.
Similar to Q2 and Q3 2020 earnings releases, Q4-2020 is showing earnings much stronger than expected, especially in the US. Analysts were too cautious after the first covid-19 related lockdowns. In Europe, the first Q4 corporate results are also encouraging. Improving earnings are a key support for equities.
Theme in Focus
Time to Rotate out of Big Tech?
Can 2021 possibly be a repeat of 2020? US mega-cap technology stocks, personified by the FAANG group of stocks (including Facebook, Apple, Amazon, Netflix and Google), rose over 100% in 2020, leading the global stock market. One of the most frequently-asked questions we receive is: “Surely this has gone too far already, so does this mean it must correct?”
Lessons of the 1990s: the 1990s were a strong decade for stock market investors. As early as 1995, noted investors such as Ray Dalio of Bridgewater and Peter Lynch of Fidelity were warning of the risks of a significant stock market correction, following the 38% gain for the S&P 500 in that year.
“Irrational Exuberance”: this was followed in late 1996 (after a further 23% gain for the S&P 500) by a similar warning of “irrational exuberance” in financial markets from the then US Federal Reserve chairman, Alan Greenspan.
1997-2000, the Nasdaq soared even more! In the five years from 1994 to 1999, the Nasdaq Composite index gained about 40% per year, rising 86% in 1999 alone, plus a further 15% in the first few months of 2000. We would conclude from this that timing the top in any parabolic market is difficult, with potential risks of missing out on huge further gains.
Where to focus in Tech today? There are two particular areas of technology that we believe can continue to perform particularly well, potentially outperforming the mega-cap FAANG stocks in 2021. These are the semiconductor industry and video games & eSports stocks.
The semiconductor sector is set to enjoy structural demand growth for processors, memory and storage chips on the back of the investment boom in 5G mobile phone and Artificial Intelligence infrastructure. This in turn will enable the Internet of Things, which will drive demand for much more semiconductor content.
US mega-cap technology companies are unlikely to outperform in 2021 as they did in 2020, given today’s far higher starting valuation levels and risks from further US and EU regulation and taxation. The technology subsectors we prefer include semiconductors, video games and eSports.
Other thematic preferences
Renewable energy under the spotlight
EU and US stimulus focused on clean energy: the combination of the EU Recovery Fund and further US fiscal stimulus from the new Democrat administration underpins the strong momentum in clean energy stocks, even after a stellar 2020 for the sector.
All clean energy indices are not created equally: interestingly, the choice of global clean energy stock index to follow has had a huge impact on investor returns over the past two years. The Wilderhill Clean Energy index has more than doubled the return of the S&P Global Clean Energy index since start-2019.
This reflects huge sector weighting differences: the Wilderhill index has a large concentration of hydrogen power, fuel-cell and battery technology companies in its methodology, while the S&P 500 index has more than 50% of its weighting in Utilities.
Clean Energy started 2021 strongly: The Wilderhill Clean Energy index rose over 20% in the month of January alone.
Small- and mid-caps (‘SMID caps’) should continue to outperform.
The extremely high valuation gap that had widened between small and large companies after the collapse of equity markets in March 2020 has been partly closed. Raymond James & Associates, an American multinational banking institution, calculated that “The Russell 2000 has outperformed the S&P 500 by 24% since March 23 compared to 51% in the early 2000s and 25% in post-Great Financial Crisis early cycle”. And again, in January this year, US small companies have gained 4.8% versus -1.1% for the S&P 500.
The estimated consensus S&P 500 P/E is 23x (expensive!); the median S&P 500 P/E is now around 18.5 whereas the median Russell 2000 (adjusted for stocks with no/low earnings) is 14x (still cheap!). The discount between small and large caps is still extremely wide on a historic basis. Furthermore, ‘SMID caps’ are expected to grow earnings faster in 2021: +41% EPS growth for the US S&P mid 400 Index and +79% for the US S&P small 600 Index.
A similar situation can be seen in European SMID caps.
Several investment themes we have been recommending are doing very well, among others: clean energy or the reflation theme including small and mid caps where we can still find value. Some specialized semiconductor companies, key suppliers for clean tech, gaming and a whole range of new technologies still have many years of structural demand growth in from of them, in our view.
We like cyclical sectors, but prefer to buy on dips
We continue to play the ongoing economic recovery via materials, industrials, as well as insurance and European energy stocks (we are positive on these sectors).
Pharmaceuticals and real estate globally as well as European tech are not overvalued; they provide diversification and reduce portfolio volatility. Moreover their outlook is also improving.
In January (see graph), several of our favourite sectors/industries performed well in Europe (materials, tech, energy, health care). That said, insurance and real estate have lagged so far in 2021.
Some doubts have resurfaced: new coronavirus strains could hamper people’s movements and delay the recovery in the services sector (including commercial real estate).
No change in our sector allocation this month.
In the United States, energy, tech and health care have been strong, while industrials, consumer staples and telecoms have lost ground.
Besides autos and energy for which we recommend selectivity (some companies are more advanced and better positioned in restructuring and in the energy transition than others), banks are cheap. But the backdrop remains challenging for universal banks with the yield curve still flat and disruption and heightened competition from online players. We still recommend selectivity for this sector.
We favour a thematic approach for technology (we like semiconductors, 5G, AI and European tech), as well as consumer discretionary, telecoms and utilities. We avoid consumer staples (expensive and too defensive).
We continue to recommend playing the ongoing economic recovery, and at this stage by buying on dips after the recent strong performance of value cyclicals and owing to some doubts relating to new Coronavirus strains and the speed of vaccination programmes in Continental Europe. Diversify with pharmaceuticals, real estate and select tech companies (semiconductors, 5G, AI, European tech).