In a recent study, researchers have claimed that a man’s ability to grow a beard evolved to help absorb blows to the head. The biologists went on to say, “we found that fully furred samples were capable of absorbing more energy than plucked and sheared samples”.
Equity markets have clearly grown their own lockdown beards as they continue to absorb the blows from economic shutdowns around the world. Asset class returns in sterling and local currency are below; it has been another stellar week for risk assets while safe havens such as government bonds and gold have pared recent gains.
Table 1: GBP total returns
Table 2: Local CCY total returns
Investors continue to face a conundrum. On the one hand emerging global economic data is dire, but on the other equity markets continue a phenomenal rebound from March lows. The narrative in the market is increasingly one of caution, with many economists playing down expectations of a V-shaped recovery and would-be epidemiologists speculating about second outbreaks in the months to come.
We looked last week  at how the FAAMGs – the top five companies in the US by market capitalisation – now make up a disproportionate amount of the S&P 500 as expectations for their future growth rates seem unimpeded by the coronacrisis. Indeed, some of the FAAMGs are actually benefiting  from the current environment. The CEO of Microsoft for example estimated that they had seen “two years’ worth of digital transformation in two months” as companies embraced everything digital from remote team working to critical cloud infrastructure. But while we speculated last week that an argument could be made around the FAAMGs trading at fair value, there are very big questions around the prospects for the rest of the market and what value an investor should attach given such uncertainty.
To break this down, we will break the market into two buckets: Growth (companies benefiting from secular trends/growing faster than the market) and Value (often more economically sensitive companies, whose profits are cyclical in nature). Having reached levels not seen since the early 2000s, Chart 1 shows just how expensive Growth currently appears relative to both its history and versus Value.
Chart 1: Although metrics such as the forward Price-to-Earnings ratio show US Growth to be expensive versus history…
|Chart 2: …we can adjust the metric for the trend in bond yields which show equities to be trading in line with historic averages
|Source: Bloomberg, EQ Investors||Source: Bloomberg, EQ Investors|
But this misses an important market factor for which we can make an adjustment: bond yields. Government bonds – generally viewed by investors as risk-free – have seen declining yields for much of the last decade driven by numerous factors including weak economic growth expectations and extraordinary central bank monetary policy. Once we make an adjustment for the decline in an investors’ risk-free rate, we can see in Chart 2 that equities are maybe not so expensive.
“Great, so let’s load up on equities” I might hear you exclaim… Well not so fast. As much as falling bond yields have been a tailwind for Growth equities over the last decade, it’s unlikely the trend will keep up its pace with a significant move in yields into negative territory. In fact, an economic recovery could well see the opposite with bond yields rising with expectations for economic growth and central banks looking to reverse some of the vast stimulus they have unleashed on the markets. In this scenario, Growth equities may see a pull-back in their valuation multiples while economically sensitive Value stocks would benefit from the upsurge in economic activity.
|Chart 3: The US Federal Reserve unleashed a gigantic stimulus package to combat the economic damage inflicted by the coronacrisis
|Source: Bloomberg, EQ Investors|
So, there we have it. If the crisis is not going away and the economic damage is going to be drawn out, innovate Growth companies whose products are uncorrelated to economic growth will continue to do well. Otherwise if we are going to see a sharp recovery and a return to “normal”, then it’s the economically sensitive Value companies that will outperform.
STAT OF THE WEEK: 25% – the proportion of the world’s tomatoes produced in Xinjiang province, China every year (United Nations).