In recent years equity markets have been dominated by the strong performance of a narrow group of popular mega-cap stocks in both the US and emerging Asia. While this provided a favourable backdrop for growth focused stock-pickers, the other side of this extremely narrow market was the ongoing neglect of a much longer list of out-of-favour stocks.
As 2020 progressed, it became increasingly apparent that the very wide dispersion in performance between the winners and losers was stretched to an unjustified level. The arrival of successful vaccines in November was the catalyst behind a rotation that is, in our view, still very much in its early stages.
How is this rotation going to play out? We have identified ten potential themes that could emerge in the months and years to come.
1. Good news already in the price
Equity markets may well continue to benefit from the tailwind of ongoing financial stimulus but they also face three headwinds: high valuations, lack of room for interest rates to fall significantly, and high government debt burdens.
Ultimately, valuations are the best long run predictor of returns. With many stocks and most major equity indices close to their all-time highs, they are naturally more vulnerable to any adverse news flow.
2. Significant opportunity for value to rebound
The market has, for an unusually prolonged period, failed to discriminate between cheap quality stocks with superior fundamentals and those which are truly facing cyclical or structural headwinds to their business models.
By early November 2020, the degree of valuation dispersion across the market had reached the extreme levels observed during the last big tech bubble of 1999-2000. The welcome news of vaccines and the fading of US political uncertainty appear to have been the catalysts for a change in market leadership.
However, the rotation we have observed since then represents only a very modest reversion in valuation multiples. The re-rating of neglected stocks has much further to run.
3. Expensive growth bubble may deflate
On the other side of the coin, the lofty expectations built into the premium valuations of many popular stocks leave little room for anything other than perfect execution.
In our view, investors fell in love with a simple “winner takes all” narrative. This has been a successful approach over the past decade but is unlikely to be repeated. Due to the current extreme valuations of many of these “chosen” stocks, the bar is now set incredibly high for them in terms of their growth expectations.
4. US market at most expensive level for five decades
The US has been the dominant market of the past few years, largely driven by a small group of index heavyweights and an increasing number of thematic stocks. As such, the US also contains the most extreme examples of excessive valuations.
There are still many good value opportunities within the US, most notably in left-behind areas such as pharmaceuticals and “old-school” technology companies, but the headwinds against the US market as a whole appear to be building.
5. Emerging Asia cheaply valued with good growth prospects
Like the US, Asia has a small number of strongly performing mega cap companies. However, overall, emerging Asia is more cheaply valued than developed markets and offers both growth and value opportunities. Asian emerging markets could perform well in the year ahead, particularly the export sensitive areas that are most geared into the global recovery.
6. Higher inflation is a short-term risk
Policymakers have been more concerned about deflation than inflation in recent years but that is likely to change. One legacy of the current global pandemic has been the removal of capacity at a time when both the monetary and fiscal policy stance is extremely loose around the world and household savings are unusually high. This could see inflation overshoot in the short run as cost-push and demand-pull forces combine, creating a new conundrum for policymakers which could rattle both equity and bond markets.
Rising inflation has historically tended to support cyclical sectors alongside the typical beneficiaries of higher rates, namely materials, industrials, consumer discretionary and banks. The key losers from inflation are areas regarded as bond-proxies, such as utilities, while many real estate stocks are already struggling due to the collapse in demand for office space.
7. Healthcare sector looks cheap
We see many opportunities in less cyclically exposed areas of the market, such as healthcare. It is a disparate sector and parts of healthcare are already very hot (e.g. biotech/genomics).
However, pharmaceutical stocks in particular look attractively valued, partly as a result of their defensiveness and partly the risk of impending US drug price regulation. We note they offer stability in the sense of robust profit margins, decent dividend opportunities and low financial leverage.
8. Environmentally focused investing is here to stay
The goal of achieving the Paris agreement suggests that downward pressure on carbon emissions will continue and companies will need to adapt.
Investment in oil and gas production is expected to remain below pre-pandemic levels for the foreseeable future at a time when firms pivot towards alternative sources such as solar and wind power. The shift towards non-fossil fuels will be a key focus for investment in the decade to come, alongside emerging technologies in battery storage and biofuels.
9. Social considerations increasingly important
The pandemic has increased awareness of the importance of social issues, particularly in areas such as mental health and rising inequality. We are strongly of the view that taking social harm into account will increasingly be accretive to future investment performance as companies become more responsive to their wider impact on society.
10. Thematic investing and “value indifferent” investors
Thematic investing is widely associated with broader trends that transcend the typical classification of stocks by their industry or sector. A good example would be the rise of the internet and social media over the past two decades. The number of potentially thematic stocks appears to be increasing by the day due to the greater pace of disruption when compared to recent decades.
At the same time, investor demand for such stocks is increasing. Retail investors are participating in the market in increasing numbers and are often drawn to popular themes, rather than focusing on valuation-based approaches. Most of the themes are likely to persist but there is an increased risk of new bubbles emerging. This is both an opportunity and a threat to long-term investors.
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Top ten market themes for 2021 and beyond
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