The coronavirus pandemic has been unprecedented both in terms of its breadth and depth, yet despite the carnage, investors to date have been willing to look past the severe economic disruption.
This has been aided by the collective stimulus measures around the world which have – and continue to – provide the global economy with a bridge as scientists search for treatments and, ultimately, a vaccine, in tackling the health crisis.
According to FactSet, global equities have returned 1.8 per cent this year, and 49 per cent since the dramatic sell-off in late March. This happened despite a 30 per cent fall in 2020 earnings per share estimates since the start of the year.*
And while there are valid reasons supporting global equity markets, including stimulus measures and historically low interest rates, the result of the US presidential race could be influential for future returns.
Markets are richly priced and do not appear to have priced in potential downside risks over the horizon, one of which is the election.
Polls and betting odds appear to be predicting a regime change with a Democrat win. If this happens, the US could be looking at potentially negative implications on corporate profits given Democrat Joe Biden’s plan to reverse Donald Trump’s corporate tax cuts, as well as potentially putting in place new taxes such as ones aimed at foreign subsidiaries.
Another source of potential downside risk is the COVID-19 vaccine progress. A number of phase 3 vaccine trial read-outs are expected to be released in the second half of October or early November. The market is generally discounting vaccine success, and any setbacks on any of these trials have the potential to unwind some of the current market optimism.
Global equity markets have also been driven by valuation expansion this year, and multiples are stretched by many measures. Some of this is a distortion and is reflective of the transitory drop in 2020 corporate earnings.
But even if we look forward to the end of 2021 where the investors are anticipating a robust recovery of corporate profits close to pre-COVID levels, markets are still expensive, trading at particularly high multiples. Valuation levels suggest that investors are expecting a strong recovery and may not be fully recognising some of the potential uncertainties in outlook going forward.
In the current market environment where market valuations are rich, especially for some of the traditional quality growth companies that have done very well so far this year, investors may be better served seeking opportunities in less crowded areas in the market.
Growth has outperformed value by more than 30 per cent so far in 2020. Investors are crowded into a narrow number of technology-related companies perceived to be relatively unaffected, or even beneficiaries, of COVID-19, resulting in an increasing level of concentration in market leadership.
The top five companies in S&P 500, FAAMG (Facebook, Apple, Amazon, Microsoft and Google/Alphabet), started the year being just 16.8 per cent of the index, growing to 22.6 per cent (as at September 30, 2020). In terms of performance, FAAMG on average returned over 40 per cent YTD while the remaining 495 S&P companies on average returned about -3.7 per cent during the same period.
While there are sound fundamental reasons why these types of businesses are preferable in the current macro-environment, the magnitude of the performance gap and valuation premium between these companies and the rest of the market suggests that the trade is very crowded, and that the risk-reward profile may be becoming less favourable.
Seeking companies with fundamentals that are inflecting positively and agnostic to whether these companies carry the traditional growth or value labels, can be advantageous in this environment.
Eaton is a good example of a company that fits this investment approach. It’s a diversified industrial manufacturer in the midst of a dramatic portfolio transformation. After these divestments, it will be a faster growing, less cyclical and more profitable business than it has been historically.
Amphenol is another example. It is a leading manufacturer of electronic connectors that is seeing growth accelerate from mid-single-digit per cent top-line growth top high-single-digit growth. Amphenol will likely continue to gain market share and improve profit margins as it expands into new addressable markets and consolidates its position in the marketplace over the long-term.
But irrespective of whether a stock carries the growth or value label and with distortive valuations priced in, all eyes will be on the US come 3 November, as the outcome will prove significant for investors the world over.
*All data are correct as of 30 September 2020.
Chris Chen, senior investment director, APAC, American Century Investments
