Global Equity Views 3Q 2021

In Brief

• Corporate profits continue to recover at an impressive pace, already breaking records around the world. The gains are very broad by region and industry, and we expect robust growth in 2022 as well.

• But high valuations, especially for fast-growing companies, restrain our enthusiasm. Most of our team expect average returns from markets, but we see good opportunities for stock selection, especially for value- and quality-oriented investors. Financials and high-quality industrials remain featured in many of our strategies.

• Three themes emerged from our recent Investors Quarterly:
  - Many Asian stocks have become more attractive after recent underperformance.
  - Investor optimism toward companies that have yet to earn a profit may be misplaced.
  - Even if the most optimistic forecasts for electric vehicle (EV) growth are too aggressive, we anticipate significant opportunities for a broad range of EV suppliers.

Taking stock

Corporate profits continue to rebound at a tremendous pace and will comfortably exceed previous record levels this year. One year after the pandemic hit, we took a look at how our forecasts have changed. We expected an acceleration of existing structural changes in favor of technology-driven disruption, internet commerce, virtual banking, cloud adoption and the like. That has proved correct, and, if anything, the changes have been even faster than expected. But the biggest surprise has been the rapid recovery in the worst-hit industries. That reflects generous monetary and fiscal policy, strong financing conditions and, of course, the effectiveness of coronavirus vaccines. Since our last Investors Quarterly, three months ago, our near-term expectations have again been revised higher, with the financial sector and industrial companies once again the biggest drivers. But the gains are very broad-based by industry and geography.

This quarter will mark the peak rate of change in profits, but we remain pretty optimistic about the outlook. Monetary policy is generally still very accommodative, although financial conditions have tightened mildly in China. Consumers are spending freely, and companies seem very able to pass on higher costs.

But with prices again moving higher, many stocks seem expensive from the perspective of our research team. An expected decline in valuations offsets part of the anticipated profit growth over the next five years, and our overall return expectations are modest. Although we expect the fundamentals of profit growth to remain strong, some caution is probably warranted in the near term after the tremendous gains made over the past year. The feverish speculative mood apparent in the early months of the year has cooled somewhat. Special purpose acquisition companies (SPACs) have fallen from favor in the U.S., and the “meme” stocks pursued aggressively by individual speculators have dropped again in recent weeks. But equity funds continue to attract strong inflows around the world.

As the momentum of the U.S. economic recovery has reached a peak, the fast-growing companies that have dominated returns over the last decade have again led the market, driving valuations back to extreme levels in some cases. Many of the recently popular beneficiaries of the reopening look fully priced, too, including many airlines and hotels (Exhibit 1). Investors have shown a strong appetite for taking risk in both new growth companies and the most beaten-down casualties of the COVID-19 crisis. Meanwhile, the virtues of high quality, steady-growth stocks have been overlooked, and on many metrics quality as an investment attribute is looking attractively priced.

Some reopening stocks are expensive … as are many stay-at-home winners

Exhibit 1: Ranges of the cross-sectional median forward P/E STM*

Source: FactSet, J.P. Morgan Asset Management. Box plots show ranges of the cross-sectional median forward P/E STM (Second Twelve Months) ratios calculated using all stocks in the industry as of each month end between February 26, 2010 and January 31, 2020. Stocks with negative EPS STM estimates are excluded from the calculation. Current median forward P/E STM ratio is calculated as of June 30, 2021. Stocks used in this analysis are constituents of the Behavioural Finance global all-cap investable universe.

Themes from our Investors Quarterly

Asian equities: Looking more attractive after recent underperformance

As the Chinese economic recovery cools down, credit issues have resurfaced, mainly in real estate. But the big news has been the official measures against technology giants, education companies and others as policymakers have imposed restraints in an increasingly forceful style. These moments of crisis, a regular feature of investing in China, should be seen from a long-term perspective. Overall, the market looks reasonably priced, and some very interesting valuations are on offer among the technology giants and other businesses impacted by political uncertainty. Investors will need to take a patient and diversified approach, but many excellent companies are now trading at significantly discounted valuations after sharp price declines. We are inclined to slowly add to existing positions as prices fall.

In Japan, we also see potential for a better market return as the vaccine rollout finally gains pace. Stocks in Japan are reasonably priced as well. The market trades at 17x forward earnings, which is actually below the average over the past 25 years—an interesting contrast to the elevated multiples evident in most other markets. Longer-term, the inexorable pressure of an aging population is creating world leaders in industrial automation and accelerating a move to digitalization in health care. But it is also pressuring drug prices as the government struggles with managing the costs. All in all, we see real potential for our research team to identify long-term trends.

Is investor enthusiasm for pre-profit companies justified?

Last year, the 130 companies in our global coverage that have yet to report a profit for their shareholders beat the market by almost 70%, and most of those gains have held in 2021. Almost three-quarters of these companies are listed in the U.S., and about 10% are listed in China. Enthusiasm for new business driven by technology is understandably high after the spectacular success of so many innovators, but history is not on the side of the optimists. Our analysis shows that unprofitable stocks are unlikely to become profitable and similarly unlikely to beat the market (Exhibit 2). However, our research team has found some stocks that it believes will buck the trend. These include well-managed e-commerce platforms in Asia generating strong cash flows. In this group, we can find stocks that are still reasonably priced. The software sector (which at 35% accounts for the largest share by industry of the unprofitable cohort) is tougher. We feel confident that some excellent emerging businesses will become profitable, but sky-high valuations limit our interest in many cases.

Loss-making companies have typically not performed well in the past

Exhibit 2: Probability of loss-making companies outperforming over time

Source: FactSet, J.P. Morgan Asset Management. This chart shows an average probability of outperforming the universe mean return over a specified horizon in months following the portfolio formation. Portfolios consist of stocks, which have not achieved operational profitability over the five years preceding the portfolio formation date, and are constituents of the Behavioural Finance global all-cap investable universe. December 31, 1994–June 30, 2021.

Who wins from the electrification of the automobile industry?

Momentum behind the long-term shift to electric vehicles (EVs) is building, spurred in many cases by proposed or existing legislation. We believe that by 2030 about 30% of new vehicle sales will come from electric-powered vehicles—not quite the 50% that the most optimistic are forecasting but still a major change. What does this mean for investors? For auto manufacturers overall, the EV transition will be a net negative; many won’t be able to sell more cars, or more cars at a higher margin, and capital intensity will go up. New entrants to the market will increase competition.

For suppliers, the outlook is much better. Batteries are the obvious theme, but semiconductor manufacturers continue to benefit from the relentless trend toward digitalization that is happening alongside electrification. Meanwhile, infrastructure investing will benefit from the rise of grid flexibility.

In short, as we illustrate in Exhibit 3, we see plenty of interesting long-term themes and attractive opportunities for research to differentiate among winners and losers.

Views from our Global Equity Investors Quarterly, July 2021

A subset of results is shown for a survey of Global Equity Investors Quarterly participants taken in July 2021. These responses are taken from a quarterly survey representing 38 CIOs and portfolio managers across global equities. GARP: Growth at a reasonable price. Black Swan: Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight. The information above should not be relied upon as a specific recommendation or an offer to buy or sell and it meant for illustrative purposes only.

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