The highly unusual nature of the Covid-19 recession has created stark differences between winners and losers. From a macro perspective, service sectors have suffered disproportionately from social distancing restrictions. But this misfortune has benefited some manufacturers as households have diverted spending from experiences to goods (Exhibit 1). This has also affected regional performance as countries with a high weight to services, and tourism in particular, have generally lagged their more manufacturing-heavy counterparts.
Exhibit 1: People have spent where they could
US goods and services consumer spending
Nominal index level, rebased to 100 in January 2018
Market performance was similarly bifurcated for much of 2020, as companies with a technology/online tilt benefited not only from their ability to grow earnings when most other sectors saw huge pressure on profits, but also from the decline in the discount rate used to calculate the present value of those future earnings streams (Exhibit 2). In the summer, the gap in valuations between growth and value stocks reached levels not seen since the technology bubble.
Exhibit 2: Growth stocks benefitted from the shifts in spending in 2020
MSCI World Growth and Value price returns
Index level, rebased to 100 in January 2020
Progress towards a vaccine has already changed this narrative as we move into 2021. On the day that the news broke of an effective vaccine, global value stocks experienced their best day relative to growth stocks since records began. The key question for next year is how confident we can be that this shift from the winners to the losers will be sustained.
Valuations alone might suggest there is more room for this rotation to run. Despite the very strong bounce in 2020’s laggards, such as financials and energy, since the vaccine announcement, both sectors still lag broad indexes substantially year to date. Cheaper valuations are also seen in regions such as the UK and Europe that are more tilted towards value sectors, while US indices look relatively more expensive given the ‘big tech’ tilt.
There may come a point at which we are looking at a more meaningful outperformance of value vs. growth. But a precursor to that, in our view, would be higher interest rates and a steeper government bond yield curve, which would be a headwind to growth stocks and would help financials within the value style. This scenario would require a greater acceleration in nominal GDP and a more rapid tapering of central bank asset purchases than we have in our core scenario. With interest rates capped by the burden of debt, we see this outcome as an upside risk rather than our central projection.
For now, we believe the key to successful allocation across equity market sectors – and therefore across regions – will be to differentiate between secular and cyclical tailwinds and headwinds. For growth sectors, the Covid-19 recession has been the catalyst for many years of technological advancement and adoption to be condensed into a few quarters. We are confident that companies will allocate a greater portion of their resources towards technology going forward, and see many beneficiaries from this secular shift, including areas profiting from advancements in semiconductor technology and the adoption of cloud computing. In other cases, though, growth stock valuations appear to assume that behaviours will permanently reflect a Covid-constrained environment. Investors must ensure that the price they are paying for any company reflects an earnings outlook and market share that can be achieved in a post-Covid world, not just the highly unusual environment of this past year.
The same debate of cyclical vs. secular can be used when assessing the opportunities in value. In very simple terms, we expect companies and countries that have suffered most during the pandemic to be the biggest beneficiaries of a vaccine. Yet medical developments cannot remove all of the headwinds for every company. Take the energy sector, for example. An improvement in the economic outlook should clearly help to put upward pressure on oil prices as demand normalises, and energy stocks should benefit accordingly. But secular headwinds remain as the world transitions away from dependence on fossil fuel towards renewables (see Global momentum towards tackling climate change). Careful stock selection will still be required.
In sum, progress towards a vaccine requires a much more balanced approach across styles, sectors and regions for next year. We expect the significant pressures on the Covid-19 laggards to ease, which in turn should catalyse a rotation across markets. But just as we avoided advocating an ‘all-in’ approach to growth in 2020, we do not see the year ahead as the time to allocate indiscriminately towards only the cheapest stocks. A vaccine will be a major step forward, but it will not cure all ailments.