2021 Midyear Market Outlook

Focus on Cyclicals and Europe

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.

Position for the Reflation Reopening Rally

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.

Target Cyclical Sectors for the Reopening

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:

  • People have begun to venture out and spend their extra savings, particularly in discretionary products, leisure, and travel,22 and this is likely to accelerate during the reopening.
  • Demand for housing and home improvement increased last year23 and the trend remains strong due to low mortgage rates,24 strong consumer confidence, and elevated personal savings.

Europe: Ready to Rise from the Double-Dip Recession

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.


Implementation Ideas

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: