Three Investment Ideas for Brighter Equity Markets
Equities have rallied recently on the back of dissipating uncertainty – the US election result becoming final, the announcement of positive news on COVID-19 vaccines – creating a brighter outlook. Following these developments, investors may want to explore underweighted areas that have received less attention this year or those that could see above average growth next year, such as mid caps, emerging Asia and ESG Europe.
Equity markets do not like uncertainty. Thus if we remove two key elements of doubt – the outcome of the US presidential election and the ability to find a successful COVID-19 vaccine – it is no surprise that equities have jumped worldwide alongside a sharp fall in the VIX volatility measure (down 40% since the end of October).
There are of course still unanswered questions around who will control the Senate and when (and how) a vaccine will be available, and Brexit risks loom large. But enough has happened in the past week to warrant thinking about portfolio changes and considering different investment ideas.
We do not believe that the prerequisites for a lasting value rally exist yet, partly based on our view that inflation expectations will not move much higher in the short term. Nevertheless, we do think investors will start to consider where they can redeploy cash or take profit (such as in certain growth areas) in order to add to underweight positions and increase cyclical exposures.
We saw some of these moves in play last week. In terms of performance, sector rotation favoured cyclicals, as well as Energy and Financials, over defensives and Technology-related sectors; high beta and value relatively outperformed low volatility and momentum; and Europe (including UK) saw larger rises than the US.1 Meanwhile, flows were high in regional equities, particularly Europe and, within fixed income, favoured corporate and high yield bonds, again in Europe as well as in emerging markets (see charts below).
Against this backdrop, we see three areas of opportunity for the coming months: mid caps, emerging Asia and Europe ESG.
Focusing on the Mighty Middle
US mid cap companies have underperformed the S&P 500 this year, through the initial COVID-19 crisis and through recovery when Technology was in favour. However, this trend has recently started to reverse. The reasons we think mid caps (in particular S&P 400) will be looked at again include:
- High level of US domestic exposure – while a fiscal stimulus package may not be forthcoming, or could be severely curtailed by a split Congress, the availability of a vaccine should encourage a return to some activity that has been locked down for months, helped by improving employment figures and confident consumer.
- Cyclical bounce back – the S&P 400’s largest sector is Industrials (18% market cap weight), which contains machinery manufacturers, electrical equipment suppliers and transport providers, and is in line for recovery.
- Smaller Technology weighting – as much as we like the sector’s structural growth prospects, many of the big players could find life tougher under Biden and are vulnerable to profit-taking. The weighting of Technology in the S&P 400 (16% market cap weight) is almost half that of the S&P 500. Perhaps more important is the lack of FAANGs, which are at risk of anti-competitive action from international bodies, even though the lack of a ‘Blue Wave’ in the US elections means it may not come from home.
- The sweet spot – company lifecycle theory suggest that smaller companies are more agile and have access to better earnings growth prospects, although the newest and smallest of those may be vulnerable to business vagaries, leaving mid caps best placed for growth without significant volatility. Such risk-adjusted returns can be seen over the last 25 years.2
- Higher asset class return forecasts long term – State Street Global Advisors expects the long-term outperformance of S&P Mid Cap 400 over its large cap peer to continue in future years, albeit with higher volatility. 3
Asia Emerging into a Better Future
We have seen significant inflows into emerging market Asia ETFs, encouraged by much brighter prospects and improved risk appetite. Despite significant gains for equities in the region already in 2020, the P/E rating (15) is still reasonable.4 Other positive drivers include:
- Election of Biden – a more moderate president should provide less uncertainty on international trade, with hope that the US may re-join the Trans Pacific Partnership.
- Strength of growth in China – although not a hidden story, the fact that China managed to produce GDP growth of 4.9% in Q3 while most of the world laboured with a recession is impressive. China accounts for 48% of the MSCI Emerging Asia Index.
- Weaker US Dollar – the currency trend over the last six months benefits countries servicing high levels of foreign loans.
- Long-term growth – State Street Global Advisors forecasts equity market returns for emerging Asia ahead of the other main emerging market regions (Latin America and Europe) for the next year and three to five years, driven by strong economic expansion in Taiwan and Korea, as well as China.
- Desire to adjust underweight positions – institutional investors are significantly underweight emerging Asia in portfolios and the more bullish outlook could accelerate the move back.5
Continued ESG Revolution in Europe
It has been good year for ESG investment in Europe, in terms of flows, relative performance against standard benchmarks and product development. We believe interest in European equities with an ESG angle could be further supported by:
- News of an effective vaccine against COVID-19 – this could have a greater impact in Europe, where the pandemic has hit particularly hard, than in other regions. A recovery in economic activity could encourage investors to move beyond the relative safety of the US.
- Biden winning the US presidency – Biden’s clean energy proposals are wide-ranging, and while not all of them will be succeed without a Democrat-controlled Senate, there is still plenty to expect favouring renewables. Biden’s social proposals have not received as much coverage; they include pursuing minimum wage rises, consumer protection and health insurance. Progress on these fronts could raise awareness of ESG beyond US borders.
- Significant progress in European ESG legislation – despite a disruptive pandemic, the European Commission has continued to bring new policy initiatives to the Green Deal, introduce ESG taxonomy and climate benchmarks, and get ready for significant reporting regulations early next year. While ESG investment is not yet mandatory, it has become increasingly hard to ignore.
- Performance of ESG funds – such funds could continue to benefit from difficult times for Energy; the International Energy Agency’s recent report highlighted the impact that COVID-19 has had on demand for last year and how much uncertainty it creates for future demand. As such, even though we have seen a relief rally in oil and gas share prices in recent days, this relief may not last.
- Relatively attractive valuations – Europe offers relative comfort on price/earnings and dividends compared with the US.
How to play these themes
SPDR offers a range of ETFs that allow investors to position for the themes described above. To learn more about these ETFs, and to view full performance histories, please follow the links below:
SPDR S&P 400 U.S. Mid Cap UCITS ETF (SPY4)
SPDR STOXX Europe 600 ESG Screened UCITS ETF (ZPDX)
SPDR MSCI EM Asia UCITS ETF (EMAD)
European- Domiciled ETP Segment Flows (Top/Bottom 5, $mn)
European Domiciled ETP Assets Category Flows ($mn)
Sources: Bloomberg Finance L.P., for the period 5-12 November 2020. Flows are as of date indicated and should not be relied upon as current thereafter.