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Mid-year Outlook: Recovery on the horizon
Joyce Gordon
Jeremy J.W. Cunningham
Rob Lovelace
June 14, 2020
KEY TAKEAWAYS
- Because this economic decline is policy driven, a solid recovery is likely as lockdowns end.
- Easy monetary policy, aggressive fiscal policy and zero-bound interest rates should continue to support equity markets.
- Low growth and inflation suggest that the low interest rate environment is likely to persist. Against that backdrop, a diversified approach and active fundamental research can prove beneficial.
Mid-year Outlook: From recession to recovery
In the opening weeks of 2020, investors had very few hints of the daunting events to come in this most unusual year. Although global economic growth was slowing, there were reasons to be cautiously optimistic.
That was then. This is now.
Over three challenging months, coronavirus-induced lockdowns have wreaked havoc on global economies. Millions have filed for unemployment benefits. COVID-19 infections appear to have peaked in many places, but the risk of secondary outbreaks remain.
Despite all of this, many stocks are down on a year-to-date basis but not necessarily out as investors optimistically look ahead to an eventual recovery. Their hopes are underpinned by massive government stimulus measures and ultra-low interest rates. Some companies perceived to be benefiting from stay-at-home mandates — including e-commerce, video streaming and food delivery firms — have rallied in the face of the worst market and economic environment since the 2008–09 global financial crisis.
As Capital Group vice chairman and portfolio manager Rob Lovelace has noted in recent investors calls, there is a unique aspect of this downturn: It was self-imposed by governments in response to a global health crisis. As such, it is not difficult for investors to imagine an end to this chapter and look forward to a post-COVID recovery period, which may have already started.
“This is different than the 2008 financial crisis — we can see the other side of the valley,” says Lovelace “It’s hard to know how wide the valley is, but I believe we will end up in a better place two years from now.”
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Positioning for a market recovery
Bear markets are painful, no doubt about it. And when you’re in the middle of a sharp decline like the one we saw in March, it feels like it’s never going to end. But it’s important to remember that during the post-World War II era, bull markets have been far more robust than bear markets, and they’ve lasted considerably longer as well.
While every market decline is unique, over the past 70 years the average bear market in the US has lasted 14 months and resulted in an average loss of 33%. By contrast, the average bull market has run for 72 months — or more than five times longer — and the average gain has exceeded 279%.
Moreover, returns have often been strongest right after the market bottoms, as investors learned in the last severe downturn. After the crash of 2008, U.S. stocks finished 2009 with a 23% gain. Missing a bounceback can cost you a lot, which is why it’s important to consider staying invested through even the most difficult periods.
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Dividends and the downturn
Another important difference in this downturn is that prospects for some dividend-paying stocks have changed dramatically. During previous bear markets, dividend stocks in aggregate have generally helped to provide a cushion against rapidly falling equity prices. Not so this year as many previously reliable dividend-paying companies have suspended or cut those payments in a bid to preserve capital.
However, rather than avoiding income stocks altogether, investors should instead consider the fundamental strengths and weaknesses of each company with an eye toward dividend sustainability going forward, notes portfolio manager Joyce Gordon.
Indeed, select companies across various sectors — including Apple, Costco, Procter & Gamble and UnitedHealth — have actually increased their dividends this year. “The key is to be really selective in this environment,” Gordon says. “Not all dividend-payers are created equal. Companies with high debt levels and a deteriorating credit outlook are particularly unattractive, in my view.”
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It’s a stock picker’s market
A dramatic shift in the macroeconomic backdrop means fundamental research is more important than ever. Attractive long-term opportunities can be found across the US, Europe, Japan and emerging markets, but selectivity is critical.
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US equities: a great divide has opened between winners and losers
It’s no surprise that business has been slow across wide swathes of the global economy. With many countries implementing strict lockdown measures, stores have shut and consumers have stayed at home. In the US, retail sales slid an unprecedented 16.4% in April, according to the US Commerce Department.
But that’s not the whole story. A look beneath the surface of the US stock market shows there has been a stark divide between winners and losers in this era of limited mobility. Not surprisingly, online retailers and grocers have enjoyed strong sales growth as consumers eat in and do their shopping in front of a screen. Providers of broadband, health care, home improvement materials and educational services have also benefited from healthy demand. Conversely, restaurants, travel and leisure companies, and aerospace companies have seen sales evaporate.
European equities: Europe faces a challenging backdrop
Economic data have confirmed the scale of the shock from the shutdowns to contain the coronavirus. Eurostat reported that eurozone real GDP fell by 3.8% in the first quarter, with notable weakness in France, Italy, and Spain. Manufacturing and services PMIs plunged in April and recovered only modestly in May. Manufacturing activity is now as weak as it was following the global financial crisis. Services activity has dropped to historic lows, implying GDP could fall by 10-20% in the second quarter.
Despite this challenging backdrop, it is possible to find some interesting longer-term investment opportunities among European-listed equities. European stocks look cheap compared to other markets. Furthermore, many of these companies are not solely reliant on the health of the domestic European economy, with many having global businesses and diversified revenue streams.
Japan: fundamental research is key
Many Japanese companies today have globally competitive businesses, with some leaders in areas such as automation, mechatronics and precision manufacturing. The country’s growing prowess in automation technologies, in particular, has been driven by an acute need to combat the negative effects of a shrinking and ageing population.
Recently, the focus has turned to those companies well positioned for the future, as Japan and the world adapts to a new normal – an environment of changed trade patterns triggered by disruptive technology and new consumer behaviours borne out of the COVID-19 pandemic. The sudden increase in the need for remote working and teleworking created a strong demand for network, personal computer, tablet, software and cloud services. Japan offers competitive companies in all these fields.
But having the right business, product, service or technology is only part of the equation. Many Japanese companies are actively improving their standard of corporate governance in response to the Corporate Governance Code, which was introduced by the government in 2015. While it will take time for companies in Japan fully appreciate and to reap the benefits of good corporate governance, many are moving in the right direction through dividend hikes, share buybacks and better balance sheet management.
Emerging markets: fundamentals are the key driver of emerging market returns
Over the past 10 years emerging market-domiciled stocks have accounted for 49% of MSCI ACWI’s top 50 stocks. Over five years, that figure increases to 62%. So, while developed markets might have posted higher returns on an asset-weighted basis, on a company-by-company basis, emerging markets have proven to be fertile ground.
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Helping propel some EM stocks is the role of fundamentals, which account for almost two-thirds of total EM returns. This means EM companies are less affected by the macro backdrop and can tap into secular growth trends such as growing middle class wealth, faster digitalisation, and greater health care consumption. This could be particularly compelling in the current environment, where economic uncertainty has increased.
Global Bonds: Lower for longer…still
Bond markets have stabilised following the extreme shock to markets in March, as governments and central banks stepped in to help alleviate financial and market stress. Their responses have been relatively swift and extensive compared with past crises such as the Global Financial Crisis. This has so far helped prevent an even greater economic decline, through interest rate cuts, bond buying, lending programmes and providing liquidity. But the temporary shutdown of the global economy is a unique event and it will be a long road to economic recovery, measured in years and not quarters.
As we enter this new reality, it becomes clear that the low interest rate environment that has prevailed in recent years is probably here to stay at least over the medium term. Central banks will likely err on the side of being conservative and accommodative. For instance, the federal funds futures market, which represents market participants’ expectations of where interest rates are heading, is pricing the federal funds rate at 0–0.25% well into 2023. We can expect to see the balance sheets of the European Central Bank (ECB), Bank of Japan (BoJ) and US Federal Reserve (Fed) reaching a combined US$20–25 trillion . There will likely also be many more announcements of fiscal stimulus programmes and extensions of expiring programmes.
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While central banks can help shore up liquidity for companies that would otherwise have been solvent were it not for the economic shutdown, we would expect to see corporate earnings fall and defaults rise. Against that backdrop, we think it is imperative to maintain a diversified approach with a strong focus on active fundamental research.
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