Barbell Cyclical and Secular Change

The positive news about COVID-19 vaccines, along with encouraging economic data,¹ has put the global economy on a clearer path to recovery. However, the lingering pandemic and the systemic behavioral change it has caused have punctured the equilibrium of societal norms — creating both continued uncertainty and new opportunities.

Although broad global equity markets appear likely to finish the year with gains² and the S&P 500 Index has posted a 1% gain on 27% of the trading days so far in 2020 (the best percentage for a calendar year since 1938),³ the pandemic continues to create an uncomfortable environment of constant change that, unfortunately, is unlikely to relent when the calendar flips to 2021.

While we are likely embarking on a period of recovery, at the same time, we must adjust to the continued evolution of corporate and consumer behaviors resulting from the pandemic. Therefore, we look to 2021 for a “recov-olution”— a period of transition that will require balancing the cyclical opportunities stemming from an ongoing recovery, alongside longer-term secular positions aimed at capturing the evolutionary impacts COVID-19 will continue to have on our society.

A hopeful recovery, but not an easy one

While the S&P 500 Index has posted the highest percentage of 1% gains in a calendar year since 1938, it has also posted losses of less than -1% on 20% of the trading days so far this year — the most since the Great Financial Crisis.⁴ And the CBOE VIX Index has spent 190 days above a level of 20, a tally higher than that of the past seven years combined,⁵ underscoring how the pandemic has created abnormally high levels of volatility.

Unfortunately, a similarly high macro risk regime is likely to persist in 2021 due to the resurgence of COVID-19 cases, which now exceed the first wave in March.⁶ And while the recent vaccine news from Pfizer and Moderna⁷ is encouraging, there is a difference between having a vaccine and getting people vaccinated. Currently, if all approvals come in on time, only 25 million people could potentially receive the Pfizer vaccine by year end.⁸ The logistics of distributing the vaccine also present challenges — particularly delivering it to developing nations.⁹ Not to mention, only 51% of Americans have indicated that they would take the vaccine.¹⁰

This high-risk regime, however, has been supported by significant monetary and fiscal stimulus and has led to positive market gains on the year. Not surprisingly, though, given the questions surrounding the sustainability of firm operations and the likelihood of future growth with so many unknowns facing our society, Quality has been one of the best-performing factors in the US and around the world, posting positive excess returns of 3.7% for the US, 10.4% for developed ex-US, 1.9% for emerging markets, and 9.6% for global universes in 2020.¹¹

The factor landscape changed following the positive vaccine news, however. Value, a more cyclical exposure that has been out of favor for the past decade — as evidenced by it outperforming Growth in just 14% of the 129 rolling five-year periods since the end of 2009¹² — has had a recent resurgence. Value stocks have rallied 17.7% so far in November, compared with 10.3% for Growth and 9.7% for the broader market.¹³ This trend of a resurgent value trade, based on the hopes of a recovery, had been building for the past three months. Value has bested Growth on nearly 60% of the trading days in the past three months — well above the full-year rate of 42% for 2020 and the average rate of 47% for the past decade.¹⁴

Value’s resurgence is not a complete surprise. To a degree, it follows the conventional playbook in a not-so-conventional time. If growth is expected to broadly improve from a more open economy as a result of a vaccine and the ability to test at home,¹⁵ then, all else being equal, investors may seek out the cheaper source of growth. For example, if two stocks are expected to grow earnings by 10%, and one trades at a price-to-earnings multiple of 21 and the other at 13, the latter will likely be chosen when there is more widespread growth — the inverse of when growth is scarce and investors are willing to buy growth at any price.

Yet, just as we likely have experienced a once-in-a-lifetime pandemic, we also expect a once-in-a-lifetime recovery that is difficult to model with any certainty. With the prospects for an uneven recovery, potentially featuring run-ups in Value and questions on the sustainability of earnings growth that may lead to further gains for higher-quality stocks, a portfolio’s core should reflect these two distinct style traits — creating additional balance that allows for more specific “recov-olution” positioning elsewhere for the potential cyclical and secular changes ahead.

Banking on a cyclical recovery

To more directly position for cyclical change in a high-conviction manner, there are a few options from a style and sector perspective. All are value/cyclically oriented, given the premise that if growth is plentiful, then consider favoring the market that offers the cheaper price to access that growth. As shown below, when compartmentalizing the US equity market by cyclicals and non-cyclicals — or even Value versus Growth — we can see how lofty earnings-per-share (EPS) growth is expected to be over the next two years for the cyclical/value components of the market. Given the difference in valuations,¹⁶ and with these expectations, it may not be a surprise to see sentiment shift upward as a result of more positive economic and vaccine data.

Buying Value, however, may not be the highest conviction position for a recovery. What’s inside Value from a sector perspective may provide more precise positioning. As part of the recovery, we may see a steeper yield curve—likely driven by a move up in long-term rates, as short-term rates are expected to remain anchored to the zero bound as a result of accommodative Federal Reserve policies.¹⁷ Cyclical exposures like Value, small cap, small-cap value, and dividend equities all have a lower correlation to the US 10-year yield than banks do (55% correlation).¹⁸ And this makes sense, given that those other exposures contain sectors that may react inversely to the curve (Utilities, Real Estate), while banks, as a result of their operations that focus primarily on the ability to borrow short term and lend to clients long term, have historically benefited from higher rates and a steeper curve. If we were to run down a cyclical recovery checklist, we would want to see:

• Positive relationship to yields: Banks have a high correlation to the US 10-year
• High expected EPS growth: Banks are forecasted to grow their earnings by 27.24% and 24.41% in 2021 and 2022, respectively¹⁹ — rates that are above broad market figures. Additionally, Financials, as a sector, has the strongest EPS momentum out of any other sector as we close out 2020 — as measured by the change in 2020 forecasts over the past three months²⁰
• Constructive valuations: Bank stocks, measured by price-to-book,²¹ trade in the bottom 13th percentile relative to their own valuation history, as well as in the bottom 3rd percentile relative to the S&P 500²²

While not on the checklist, positioning trends for banks may add to the potential upside if a cyclical recovery takes. Per the Bank of America Fund Manager Survey, shorting banks was the second-most crowded trade as of November 17, 2020,²³  and a turn in sentiment may lead to short covering and, therefore, upward price appreciation for banks as result. Altogether, if an economic recovery does take shape, cyclical assets may benefit from the broad-based increase of economic growth, and bank stocks may be the ideal cyclical change candidate for 2021.

Ch-ch-ch-ch-changes, turn and face the strange

Technological innovation will continue reshaping our way of life. It will touch every industry and be the catalyst for new ones (like telehealth and e-learning). We are likely to see demand for advanced medicine, improved structural health care processes, and remote access capabilities to support reduced-contact interactions. Digital payments will become more standard, while video games, streaming networks, virtual reality, social media and interactive home workout equipment will likely move from being “discretionary” items to “staples” in the future.

COVID-19 has also shifted our mindset toward infrastructure spending, given the number of individuals working from home and relying on connected devices. It has also highlighted the need for crowd management, building safety protocols, and smart grids for the change in power consumption. A Barclays report estimates that Smart Cities have the potential to generate $20 trillion in economic benefits by 2026.²⁴ There is precedent to support this prediction. Back in 2008, coming out of the Great Financial Crisis, South Korea put almost 80% of its stimulus spending toward sustainable measures, and the International Monetary Fund recognized the country’s recovery as one of the swiftest and most successful in the world.²⁵ For today’s recovery, governments are seeking to use the same playbook, as President-elect Biden’s infrastructure agenda is focused on investing in modern and sustainable infrastructure, and recently, the European Commission’s €750 billion economic stimulus plan featuring sustainable infrastructure renovation was agreed upon by Parliament.²⁶

While COVID-19 is a humanitarian crisis first, it has also resembled a global security event in terms of travel restrictions, compromised video-hosting platforms, and brought about a near-total transition to digital payments — leading to the need to have more improved cybersecurity measures in a more digital world. As shown below, the trend of digital connectivity has been growing over the past few years and, given our new digitally connected but physically separate world, this trend is likely to strengthen — mainly from the rising number of connected devices. Prior to the pandemic, the average US household had 10 connected devices²⁷— up from five a few years prior²⁸— and this number is likely to increase to potentially 20 by 2025.²⁹ This follows the similar pattern of data usage by zettabytes, as from 2015 to 2019, data volumes increased 165%, and they are expected to increase by 263% between now and 2024.³⁰

While these trends existed prior to COVID-19, the pandemic has accelerated the adoption of certain behaviors by a few years — creating new future growth opportunities. These behavioral changes are not a one-off for our society, but transcendent trends that will impact future generations across a variety of different parts of our economy.

Overlooking these broad-based innovation trends may reduce a portfolio’s opportunity for growth and its potential participation in secular change. In fact, if we compile all broad innovation thematic ETFs into one portfolio and average the consensus analyst estimates of these innovative firms’ 3-5 year EPS growth, we find that all of the stocks in the thematic ETF portfolio are expected to grow earnings by 19% over this time period, versus growth of just 12% for the average S&P 500 firm.³¹

This inflection point of behaviors may present opportunities that are not currently well represented in traditional market exposures. When targeting these broad-based thematic trends where idiosyncratic or firm-specific risk may be elevated, since not all firms innovate successfully, a diversified investment approach that is non-market-cap weighted may be optimal.