Expansion. That’s the conundrum for investors in 2021. Or, to be more precise, how markets will adapt to the huge expansions of earnings multiples and debt in 2020.
The first one is perhaps easier to deal with. Markets are supposed to price with some efficiency. Rising P/E multiples either mean higher prices or lower earnings – or potentially both.
Earnings collapsed in many sectors last year. Using the S&P 500 as an example, returns were driven by multiple expansions in most cases – healthcare being a notable exception. Today, most sectors are trading at 10-year highs. So the logic follows that we need very meaningful earnings growth for equity markets to make headway. More than that – and assuming markets have priced earnings growth efficiently – we need to see positive earnings surprises. That might be a tough hurdle for markets.
Hunting for inefficiencies
Luckily, markets are nowhere near as efficient as some would believe. And this inefficiency throws up numerous opportunities for the active investor. A key learning of the global financial crisis, for example, was that companies which were aggressive in their restructuring gave plenty of scope for earnings surprise in the years that followed. The reason was simple – investors continually underestimated operating leverage in business models where costs have been cut aggressively. This opportunity will be one of the characteristics our managers seek for their funds in 2021.
The UK looks cheap
There are also idiosyncrasies in markets, the UK equity market being the most extreme example. UK equities lagged the recovery in other markets from 23 March last year. And they remain undervalued. Many discrete sectors in UK equities look very cheap compared to both their history and, for example, their equivalent US sectors. With Brexit resolved and a weaker US dollar, asset allocation to the UK is likely to increase. Not to mention the burst of activity from private equity and corporates from overseas already seen in 2021.
Cyclicals or more tech?
Emerging markets could also be a good way to play the cyclical recovery and even protect – to some extent – against inflation. More difficult to see from our current position is how technology stocks will fare over coming years. It could be that we are still early in the technology bull market. Looking back at the dotcom era, large cap tech stocks grew to a much larger proportion of the S&P 500 and Nasdaq before peaking. I wouldn’t want to suggest we are likely to see a further rally in technology, but I wouldn’t completely dismiss it either.
What about the macro?
All of the above is clear from an ‘investment fundamentalist’ perspective. But what’s the elephant in the room for these arguments? Rationalising discounted cashflow models can go some way to explaining the types of stocks favoured in 2020. And the glut of fiat money augurs a benign environment for equities in particular. But is this too simplistic?
This question forms part of the second ‘expansionary’ conundrum. Monetary and fiscal stimulus. As the former was ramped up in response to the pandemic, assets prices responded accordingly. The latter has had to be extended to directly feed into economies. And everyone is waiting to find out how, when or if it will be recouped.
Inflation concerns on the rise
This feeds into the bigger concern for investors: inflation. After a decade in which inflation expectations declined, we now seem to be entering into a period in which they are increasing. How soon and how persistently this becomes an issue for bond and equity markets is up for debate. One view among our fund managers is that there will be spikes in 2021 as year-on-year comparisons roll into focus. Others point to the expansion that government and central bank balance sheets have undergone and posit inflation as an inevitable consequence. Timing seems the key variable here. Given the lagging nature of inflation as a measure, it’s likely to be a debate that plays out over at least the next year if not longer.
Expectation of inflation is likely to be a big issue not only because it could cause a significant shift in investment sentiment. It is also because if we don’t see inflationary pressures building, then the next question investors will start to ask is just how are governments going to deal with their current and growing mountains of debt.
Responding to the inflation challenge
If we are likely entering into a world of higher inflation, it heralds sector rotations and an opportune environment for active managers. It would be suggestive of cyclical companies performing better, both in equities and in corporate bonds. And it signals a potential return to value. We have spoken previously about the opportunity that might exist in industrials and also in financials. These are just some of the areas in which our managers see opportunities.
Matt Beesley is CIO at Artemis
