Equities Focus
Summary
- Equities not so expensive in an “everything is expensive” world: while global equities’ forward PE of 18.7x looks expensive against a long-term average of 15x, government bonds, credit and cash look even worse value. We maintain our positive stance on equities.
- Long-term expected stock market returns remain positive: the combination of dividend income, profit growth and P/E valuations point to 5%+ nominal long-term expected returns for Euro, UK, EM and Japanese equities, with US a little lower. Prefer world ex-US equity exposure.
- Growth has rallied, but don’t give up on Value: the equal-weighted Nasdaq 100 reached new all-time highs at end-June, underlining the resurgence of the tech-led growth factor in June. But with higher long-term rates and investment growth in prospect, Value should still do well.
- More positive on China internet: following a 31% sell-off in Chinese internet stocks on the back of increased regulatory scrutiny and subsequent fines, we believe these stocks will benefit from strong e-commerce and product momentum e.g. in video games in H2. We turn positive on the China technology sector.
- Sectors – Upgrade Construction Materials to positive: this sector should profit from US and European (green) infrastructure investment plans, and ongoing pricing power.
Global Equities view
Are stock markets too expensive?
Should I stay or should I go? Investors are understandably nervous about their stock market exposure, after a near-30% rise in global equities since the end of October 2020. No one wants to be long of equities, should they experience another sharp bear market as seen only too recently in March 2020, and before that in late 2018.
But ex-US valuations have not risen much globally of late: the MSCI World ex-US index’s forward PE ratio has only risen from 15.8x in October 2020 to 16.2x today. Since November 2020, forward earnings have risen 26% on strong quarterly earnings reports, as the world recovers from pandemic-induced recession.
Equities not so expensive in an “everything is expensive” world: while the S&P 500’s 12-month forward PE of 21.3x looks rich compared with a 16x long-term average, other asset classes such as government bonds, credit and cash look even worse value. World ex-US stocks represent better value.
The trend remains our friend
The majority of stocks trend higher: 92% of S&P 500 stocks sit above their own 200-day moving averages, with Europe close behind at 88% of STOXX Europe stocks above their own 200-day moving averages.
The 65%, 50% stock allocation rule: the proportion of stocks above their 200-day moving averages remains a potent indicator for equity allocation. Allocation to stocks can be simplified to a basic rule – if the proportion of stocks exceeding their 200-day moving average is 65% or above, then one can be fully invested in equities.
If, however, this proportion is between 50% and 65%; then one should only be 50% allocated to stocks. Below 50%, one should not have any allocation to stocks.
Implementing this allocation rule in 2018 and 2020 would have avoided much of the drawdown in equity markets on each occasion; although one would also have been slow to buy back into the subsequent market rallies. For now, this rule suggests maintaining a full exposure to equities.
CONCLUSION
It seems too early to reduce equity exposure while trend-following works so well in the midst of a strong global economic recovery. Most importantly, central banks continue to fuel liquidity growth, while governments are also boosting growth via fiscal spending programmes. As always, watch for the US Federal Reserve’s first moves to ”take away the punchbowl” via tapering and, eventually, interest rate hikes. This will be a sure sign to adopt a more cautious asset allocation stance.
Top themes
Play semis for Artificial Intelligence, global chip shortages
We remain believers in Semis: the key segment within technology that we continue to prefer is semiconductor companies, notably semiconductor equipment makers. Not only are chipmakers at the forefront of developments in artificial intelligence and machine learning; but they also benefit from the global explosion in demand for central and video processor, memory, storage, sensor and 5G-related semiconductor chips.
Since 2014, the semiconductor has led the performance in the wider tech sector, with an annualised performance of nearly 27% per year on average since 2009. This compares with 20.4% for the Nasdaq Composite, and 15.5% for the S&P 500 indices.
Think of silicon chips as the basic building blocks of modern computation, the 21st century equivalent of ball bearings that you find in every motor that enabled the Industrial Revolution.
Include a quality bias into your stock market exposure
Quality will win out (over time): our longstanding bias to the Quality factor, particularly in European equities, continues to play out well in 2021. So far this year, the Europe Quality factor index has gained 16.6% since the beginning of the year; 0.7% ahead of the benchmark MSCI Europe index. This adds to the better performance over time of the Europe Quality factor, which has gained 54% cumulatively since the start of 2018, far ahead of the MSCI Europe’s 24% over the same period.
Quality provides a partial downside buffer: a good portion of this relative outperformance has been generated in bear market phases such as Q4 2018 and Q1 2020, when the Quality factor lost less ground than the benchmark index (i.e. Quality has a downside beta of less than 1).
ESG/SRI indices benefit from a clear Quality bias: recall that broad sustainable equity indices tend to have a quality bias by construction, and have also demonstrated similar outperformance since 2016.
CONCLUSION
Key thematic convictions for July (and beyond) include the semiconductor sector, Chinese tech (after a substantial sell-off since February) and both global and European Quality factor exposure (e.g. via ETFs and funds).
Sector outlook
We like cheap/ lagging sectors with improving fundamentals and cash flows
Growth and real estate sectors have performed well in June, while in contrast deep cyclical sectors such as Financials and Basic Materials have consolidated due to the retracement in inflation expectations and the correction in long-term bond yields.
Prefer European real estate: Real estate in the US has recovered very well this year. Momentum remains strong and fundamentals continue to improve, but we now suggest focusing more on European real estate, which has lagged over this recovery so far.
Other cheap sectors or with good/improving momentum include Health Care, Financials (we expect very good returns to shareholders in the coming years!), Semiconductors and European Energy. Vulnerable segments are ultra-long duration stocks, especially those with disappointing, little or no earnings (mainly in the tech space; we suggest reduce exposure to this segment on any rebound).
We now upgrade Construction Materials to +
Year-to-date, aside from US real estate, cyclicals are still leading the pack (see chart in page 5). We have become more selective among cyclicals. Alongside Financials, we like some sub-sectors of Materials, such as Precious Metals and Construction Materials - which we now upgrade to Positive. These segments should indeed be key beneficiaries of the US and European green recovery plans.
Construction Materials companies offer more and more green solutions, such as isolating materials and carbon capture. Infrastructure plans and new trends in housing should support construction for many years and we believe this potential is underestimated by the market. Besides, inventories are low and balance sheets are now quite solid.
News flow to come: in the coming weeks, we will observe how quickly China is cooling down, how the new coronavirus Delta variant spreads and impacts the global economy, and to what extent inflation and rising rates/yields remain major concerns.
CONCLUSION
We suggest sound diversification, favouring the cheapest sectors with good or improving cash flows among cyclicals and defensives. Financials, Health Care, Real Estate, Precious Metals, Construction Materials, Semiconductors and EU Energy look the best sectors to hold. In contrast, avoid Utilities and sub-industries that could suffer from rising energy/raw material prices such as Household and Personal Care products. We upgrade the Construction Materials sector to Positive.