Following a once-in-a-lifetime crisis, the global economy has begun a once-in-a-lifetime recovery fueled by the trifecta of accommodative monetary policies, fiscal stimulus, and most importantly, COVID-19 vaccines. As doors begin to open fully in the US, roughly $2.6 trillion of excess savings1 that has been sitting on the sidelines could filter down into the real economy — accelerating a burgeoning economic expansion.
While beta is likely to continue to be rewarded as the baton is passed from recovery to expansion, we look for an anything but a basic beta rally. As a result, discrete tactical asset allocation adjustments may help you harness the disperse return environment (trailing six-month sector return dispersion is in the 98th percentile over the last 25 years).2
Led by cyclical segments, the US has powered the global recovery so far. As reopening accelerates, cyclicals are likely to sustain their recovery momentum as a result of improving fundamental growth, rebounding economic data, and still-accommodative policies facilitating liquidity and risk taking. Meanwhile, European equities may start to play “catch-up” to the US, as a result of the rebound in earnings sentiment, vaccination progress, and reductions in mobility restrictions that have already started to improve the overall fundamental and economic outlook.
With more than 40% of all US adults fully vaccinated for COVID-19, new daily confirmed cases have fallen to their lowest level in 11 months.3 As a result, 28 states are fully reopened and 21 states are easing COVID-related restrictions, such as restaurant capacity limits, group gathering limits, and non-essential business openings.4 According to the Google Mobility Trends report, US mobility has increased noticeably since February, with parks, retail, and recreation improving the most.5
More vaccinations may lead to a faster and more sustainable reopening. And President Biden expects at least 70% of American adults to have at least one dose of the vaccine by July 4th,6 potentially accelerating both mobility trends and the economy.
The sizable fiscal stimulus and improved mobility have provided tailwinds for consumer spending — a main driver (70% of US GDP) of the Q1 US economic rebound that has left GDP within just 1% of its pre-pandemic peak.7 And there is still a lot of dry powder left. Following the $1,400 stimulus check distribution, the personal savings rate jumped up to 27.6% of disposable income 8 — the second-highest level on record. And more stimulus is on the way. Starting in mid-July, 39 million US households will begin receiving monthly child tax-credit payments of around $300 per child for the rest of the year.9
Given these tailwinds, 2021 US GDP growth revisions are higher than the changes to growth for the eurozone, Latin America, China, and Japan regions/nations since the start of the year.10 And in a fast-growing economy with rising inflation, assets with a greater sensitivity to rates and inflation may be one of the primary beneficiaries of this macro environment. As shown in the chart below, of all the major asset cases, value and small-cap stocks have historically shown some of the highest correlations to 10-year yields and inflation expectations.
Equity Rate and Inflation Sensitivity
Beyond the constructive macro sensitivities, positive earnings sentiment for both value and small caps are supportive. Small-cap equities are expected to grow earnings per-share (EPS) by 47% over the next 12 months.11 Meanwhile large caps are expected to grow their bottom line by just 26%.12 Similarly, value stocks are estimated to post 30% growth versus 20% for growth stocks.13 These 21 and 10 percentage point differences in EPS growth for small caps and value stocks relative to large caps and growth stocks are in the 94th and 89th percentiles, respectively, over the past 20 years.14 This illustrates both the higher forecast for cyclicals and the stark dispersion in earnings expectations.
Lastly, while small caps and value stocks have rallied by 22% and 18% percent this year,15 respectively, valuations are not stretched. In fact, both their relative valuations (value-to-growth, small-to-large) based on price-to-earnings-next-twelve-months (P/E NTM) ratios are sitting in their respective lowest decile over the past 20 years.16 As a result, overweighing small caps and value stocks in the core may help you position for reopening opportunities that come at inexpensive valuations.
As noted earlier, sector dispersion is elevated. This creates a conducive environment for overweighting and underweighting sectors to pursue alpha. During the reopening, we see four sectors that could potentially benefit from our current macro backdrop: banks, miners, retailers, and homebuilders. Banks and miners are our highest conviction market exposures.
Banks and miners both plot in the upper right quadrant of the earlier inflation and rate sensitivity chart. Banks have a correlation of 66% and 80% to breakevens and rates while miners have 65% and 57%, respectively. Also, earnings for banks and miners are expected to increase by 61% and 377% for 2021, respectively. This handily beats the S&P 500 earnings growth expectation of 33% for 2021.17 And like small caps and value stocks, the relative valuations for banks and miners are constructive — plotting in the fourth and first percentiles over the past 15 years based on P/E NTM.18
Outside of macro and fundamental trends, another tailwind for banks is that with the economy improving, banks have started releasing credit-loss reserves that they built up during the pandemic — boosting industry earnings and return of capital to shareholders.19 And if the economic reopening shifts into a higher gear, business activities will likely pick up, leading to greater loan demand that could increase earnings even more.
For miners, the further expansion of global manufacturing activity20 will likely create stronger demand for industrial metals. As a result, the rally in metal prices is likely to continue, benefiting metal producers and miners — a segment that has seen 2021 earnings improve by 212 percentage points from the start of the year. The pressure on metals prices is also a result of supply side trends. In April, the wait time of manufacturers for production materials extended to its longest since 1987, and input prices increased for the 11th straight month to their highest since 2008 — indicating scarcity of supply-chain goods.21 Lastly, any infrastructure spending should add more upward momentum to the industry’s upbeat economic and fundamental outlook.
For retailers and homebuilders, the positive outlook centers on two main points:
Slow vaccine rollout and reinstated lockdown measures amid the resurgence of the pandemic earlier this year took a toll on euro-area recovery, pushing the region into a double-dip recession in the first quarter. However, as the EU countries overcome logistical hurdles and boost vaccine supplies, the surge in new cases has begun receding and mobility restrictions have been eased. As of early May, 36% of the region’s adult population has received at least one shot.25 And it’s projected that the EU will have enough vaccine doses to inoculate 70% of its adult population by mid-July.26
Beyond the health and humanitarian tailwinds, the first round of disbursement of funds from the €672.5 billion Recovery and Resilience Facility is likely to come through in the second half of this year, 27 providing substantial fiscal stimulus to propel public and private investment — further strengthening the region’s recovery. Strong external demand from its major trading partners — the US and China — also bodes well for a rebound of GDP growth and corporate earnings.
Given the initial delay in recovery, there is more room for improvement in the coming months and potentially more upside surprises. In fact, an EU economic sentiment survey recently found that economic activity has started to shift into a higher gear. Confidence across business sectors, including industry, services, retail trade, and construction, has improved significantly above its long-term average and pre-pandemic levels.28 Consumer confidence has also picked up markedly, rising above its long-term average. 29 Given these tailwinds, the European Commission upgraded its 2021 and 2022 GDP growth forecasts by 0.5% to 4.2% and 4.4%, respectively in May.30
European Economic Sentiment
Further to the positive economic trends in the region, on the back of strong earnings sentiment in Q1, analysts have also raised 2021 EPS growth estimates of European equities to 42%, eight percentage points above 2021 US EPS growth estimates.31 And this growth is not accompanied by the elevated valuations of broad US large caps. The region’s valuations relative to the US are at their bottom percentile over the past 15 years based forward price-to-earnings and price-to-book ratios.32
Lastly, European equities’ more cyclical composition (overweights to Industrials, Materials, and Financials relative to US equities) means they may also benefit from the broader global cyclical recovery.
With the US economy entering a burgeoning expansion and Europe starting to rebound more strongly, you may want to alter positioning to be more cyclical and focus on Europe.
Consider cyclical core US exposures:
Consider overlaying cyclical sectors like banks and miners:
Consider seeking a “catch-up” opportunity in Europe:
1 Americans are sitting on $2.6 trillion in excess savings from the pandemic that can help power a recovery, Moody's says, Business Insider, April 19, 2021.
2 FactSet, as of May 17, 2021 based on the S&P 500 GICS Sectors.
3 New US Covid infections fall to lowest level in 11 months, Financial Times, May 10, 2021.
4 KFF.org. Kaiser Family Foundation, as of May 10, 2021.
5 Google, May 10, 2021.
6 Biden Sets New Goal: At Least 70% Of Adults Given 1 Vaccine Dose By July 4, NPR, May 4, 2021.
7 Bloomberg Finance, L.P., as of May 17, 2021.
8 US Bureau of Economic Analysis, as of March 31, 2021.
9 Biden’s Child Tax Credit Boost to Send First Payments on July 15, Bloomberg May 17, 2021.
10 Bloomberg Finance, L.P., as of April 30, 2021.
11 FactSet, as of May 17, 2021.
12 FactSet, as of May 17, 2021.
13 FactSet, as of May 17, 2021.
14 FactSet, as of May 17, 2021.
15 Bloomberg Finance, L.P., as of May 17, 2021 based on the performance of the S&P 500 Value Index and the S&P 600 Small Cap Index.
16 FactSet, as of May 17, 2021.
17 FactSet, as of May 11, 2021.
18 FactSet, as of May 17, 2021.
19 Fed says banks will have to wait until June 30 to start issuing buybacks and bigger dividends, CNBC.com March 25, 2021.
20 JP Morgan Global PMI Index above 50 since July per Bloomberg Finance, L.P., as of May 17, 2021.
21 ISM April, 30, 2021.
22 McKinsey’s March consumer sentiment survey.
23 US Home Sales hit a 14-year high and the NAHB Remodeling Market Index is at all-time highs and 71% above its long-term 15-year average per Bloomberg Finance, L.P., as of May 17, 2021.
24 30-year FNMA Fixed Rate Mortgage rates are 35% below their 20-year long-term average per BankRate data, as of May 17, 2021.
25 COVID-19 vaccine rollout overview, European Centre for Disease Prevention and Control, as of 5/9/2021.
26 EU will have vaccine doses for 70% of adults by mid-July, Medical Express, April 20, 2021.
27 First recovery euros could be paid out in July, EU Observer, May 11, 2021.
28 European Commission, April 2021.
29 European Commission, April 2021.
30 Spring 2021 Economic Forecast: Rolling Up Sleeves, European Commission, May 2021.
31 FactSet, as of May 11, 2021.
32 FactSet, as of April 30, 2021.
Earnings Per Share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
MSCI Emerging Markets Index
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging markets countries. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI EAFE Index
An equities benchmark that captures large- and mid-cap representation across 22 developed market countries around the world, excluding the US and Canada.
Price-to-Book Ratio, or P/B Ratio
A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities. The P/B is a ratio of investor sentiment on the value of a stock to its actual value according to the Generally Accepted Accounting Principles (GAAP). A high P/B means either that investors have overvalued the company, or that its accountants have undervalued it.
Price-to-Earnings Multiple, or P/E Ratio
A valuation metric that uses the ratio of the company’s current stock price versus its earnings per share.
S&P MidCap 400 Index
A benchmark that seeks to target the mid-cap portion of the US equities market. The index covers more than 7 percent of the U.S. equities market. Included in the index are companies with market cap in the range of $1 billion to $4.5 billion. This range is reviewed from time to time to ensure consistency with market conditions.
S&P 500® Growth Index
A market-capitalization-weighted index developed by Standard and Poor's consisting of those stocks within the S&P 500 Index that exhibit strong growth characteristics.
S&P 500® Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
S&P 500® Value Index
A market-capitalization-weighted index developed by Standard and Poor's consisting of those stocks within the S&P 500 Index that exhibit strong “value” characteristics.
S&P SmallCap 600 Index
Market capitalization-weighted measure of the performance of small cap equities within the United States, with constituents required to demonstrate profitability prior to gaining initial inclusion.
A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be “flat,” it means the difference in yields between bonds with shorter and longer durations is relatively narrow. When the yield curve is said to be “steep,” it means the difference in yields between bonds with shorter and longer durations is relatively wide.
The views expressed in this material are the views of Michael Arone, Matthew Bartolini and Anqi Dong through the period ended May 17, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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Diversification does not ensure a profit or guarantee against loss.
Investing involves risk including the risk of loss of principal.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Foreign (non-US) securities may be subject to greater political, economic, environmental, credit and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole.
Concentrated investments in a particular sector or industry (technology sector and industrials sector) tend to be more volatile than the overall market and increases risk that events negatively affecting such sectors or industries could reduce returns, potentially causing the value of the Fund’s shares to decrease.
When the fund focuses its investments in a particular industry or sector, financial, economic, business, and other developments affecting issuers in that industry, market, or economic sector will have a greater effect on the Fund than if it had not done so.
Multi-cap Investments include exposure to all market caps, including small and medium capitalization (“cap”) stocks that generally have a higher risk of business failure, lesser liquidity and greater volatility in market price. As a consequence, small and medium cap stocks have a greater possibility of price decline or loss as compared to large cap stocks. This may cause the Fund not to meet its investment objective.
Index-based funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
A “value” style of investing emphasizes undervalued companies with characteristics for improved valuations. This style of investing is subject to the risk that the valuations never improve or that the returns on “value” equity securities are less than returns on other styles of investing or the overall stock market. Although subject to the risks of common stocks, low volatility stocks are seen as having a lower risk profile than the overall markets. However, a fund that invests in low volatility stocks may not produce investment exposure that has lower variability to changes in such stocks’ price levels.
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