Recoveries, by definition, are transitory. This is true whether we’re talking about an economic recovery, a stock market recovery or an injury recovery.
They consist of a period of time following a setback, with an opportunity to see faster improvements than during a normal expansionary phase. This is not guaranteed, of course, as any athlete with hamstring problems can attest. Or if you grew up in 1990s Japan, where the “recovery” is arguably still going, beset with countless setbacks.
But they do eventually end, by definition. At some point, it stops being a recovery and it becomes the start of a new expansionary phase, at least until the next setback occurs. Yet, recoveries do represent an outstanding period for investors, with a desirable blend of positive data flow, fast growing earnings and the return of once fearful investors. It can be a period where all ships rise as the tide changes, creating a cyclical upswing.
Turning to today, most of the cyclical upswing may now be behind us, although we continue to see positives. The key now is to stay a step ahead of the pack, knowing what may come as the recovery matures, ultimately positioning portfolios in a way that reflects forward-looking realities.
Our take on today’s recovery
The economic recovery has been unique and powerful. The supportive environment is evolving quickly since the economy bottomed in mid-2020, with a stellar recovery in both the economy and markets. Perhaps so strong that it is no longer valid to call it a recovery. We’ve seen economic activity revert towards pre-pandemic levels and wage inflation is rising.
From an investor’s perspective, we saw the classic recovery plot, with equity investors leading the economic recovery (the price-to-earnings ratio expanded) before corporate earnings picked up and took the driver’s seat (as earnings accelerated, the P/E ratio deflated).
In a forward-looking sense, many market participants are still encouraged by the economic recovery, with strong corporate earnings and cheap interest rates, so continue investing full throttle. Others are beginning to question the durability of the recovery. We’d just comment that this type of bifurcation among market participants is very normal at this stage of a recovery, as economic maturity increases, and the positive dataflow somewhat softens.
Moving ahead
To capitalise on the broader recovery story, it is important to play through the probable economic pathways from here to determine how our positioning might fare. The first, and perhaps most likely scenario, is that the economic recovery is set to morph into a new economic expansion, despite some obvious headwinds.
If such a scenario transpired, our analysis suggests that in previous recoveries from global recessions, value outperformed growth more significantly. This might suggest there is still room for value stocks to outperform.
Other pathways that we must face up to include fundamental risks that are unique to this recovery. Prominently, a key risk is that this recovery was an expensive one. With both federal government and central bank support in the trillions globally, we averted a major economic crisis, yet the policy exit is fraught with danger. We further acknowledge some other key downside risks, including:
- -Inflation,
- -Covid variants,
- -Corporate capital supply. The ease by which companies can access capital via equity raisings is a potentially worrying development (from venture capital to SPACs and IPOs).
- -High valuations. The Covid sell-off was short-lived, and the market was arguably overpriced going into the correction.
In our view, these are the are “known unknowables”, with each development having widespread probabilities attached to it. It is for this exact reason, we believe it’s imperative to diversify the risk drivers in portfolios to be positioned for investor success in many outcomes, not just one.
That is why our investment management team runs portfolio robustness analytics on our multi-asset portfolios. The central idea is to assess performance across a range of macroeconomic and capital markets scenarios. We also deeply analyse the fundamental drivers of our best research ideas and dominant portfolio positions. Identifying common factors is imperative in our world view.
It is obviously difficult get everything right, as no one carries a 100% strike rate. Portfolios must reflect our best research and balance risk and reward. So, even when this economic recovery ends, which it will by definition, we are still well equipped to empower investor success.
Leslie Alba is an associate director of investment management research at Morningstar
