The Global Equity Market Outlook
Man: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.
Kathryn Pasqualone: Welcome everyone and thank you for taking the time to join us today. My name is Kathryn Pasqualone, and I'm the client advisor within the North America institutional business here at JPMorgan Asset Management.
I'm pleased to introduce my colleague, Paul Quinsee, our Head of Global Equities.
Over the next hour, we're going to shed some light on what we're seeing in the market and how it's impacting global equities. In order to facilitate this discussion, I'm going to pose some questions that I've prepared for Paul.
So, Paul, why don't we jump right in? Your team meets quarterly to discuss what we're seeing in the market and our outlook for the next three to five years. Can you talk to us about the recent quarterly strategy summit and some of the conclusions that have been drawn from this meeting?
Paul Quinsee: Sure, I will be happy to. Thanks, Kathryn, and hi to everybody.
First of all, what is our quarterly strategy session? So, in global equities, we are investing actively in all three regions -- Asia, Europe, U.S. We based everything on fundamental research with our portfolio teams, we'll focus on one part of the world's markets and take their own position. So they're not always going to agree on everything. And they don't have to either. But we do think there is a value in getting the teams together once a quarter to share their ideas on the big trends, the best opportunities, the biggest risks.
And we did it this time on March the 24th. At that point, the S&P was a little bit off the lows but still almost 30% below where it had been a month before. As a few weeks have passed since then, and one could almost begin to get used to what we're dealing with here, perhaps worth remembering the scale of the shock to markets that we had just seen was truly historic proportion. We had the fastest 20% drop in U.S. equity since the Great Depression. We were experiencing the highest volatility in equity markets ever, higher even than what we saw in 2008, and frankly, I never thought we would live through that kind of volatility again. We saw of course, as you know, from calls earlier with Bob Michael, there is much pressure on the debt market as in 2008 when the entire health of the world's banking system was in question.
And all of this really came from nowhere. So, whereas in the Great Financial Crisis markets had peaked about a year before the crisis really intensified in September 2008, you know, the failure of Lehman Brothers, by that point the S&P was already down around 15%. Some of the problems were already in people's minds. This time, U.S. equities had hit a record-high on February the 19th. Just 20 trading days later, stocks had lost a third of their values. So it was an incredibly dramatic backdrop to the discussion.
I'd say we had three conclusions. The first was that markets are attractive. Now, for every one of these sessions, I asked each of the 30 portfolio managers what they think about markets, and I give them one of three choices -- better than average returns from here; average; or below average. Just to keep it simple. And 90% of the group this time said they thought market returns would be attractive from that starting point. I've never seen such a strong consensus as that.
And I think there were two sort of forces behind it. One, reading in sentiment, which is a good contrarian indicator, at least in the near term, was incredibly negative. (Unintelligible) our team in New York, for example, measures what the market thinks about the stocks in this portfolio based on (unintelligible) target prices, momentum, and stuff like that (unintelligible) record complacency to record panic in just a couple of weeks. And we saw similar things around the world, so that investments had already got very scared and very nervous.
And secondly, valuation. Valuations were pretty reasonable in most markets around the world and actually downright cheap in some.
So, reasonably positive on markets taking a (three-year) view whilst recognizing the short-term things are still very difficult. Secondly, opportunities for stock duration within markets, very high. Tremendous stock (dispersion), tremendous dispersions fundamentals, and as we'll get onto a little later in the call, tremendous dispersion in the way stocks were being priced. All that suggested great opportunities for active management to get that right.
And thirdly, sort of balancing this, incredibly high near-term risks. So we were dealing with not just a slowdown but a shutdown. And at that point (unintelligible) still unfolding, it was already very impressive, of course, central banks through $1.4 trillion worth of securities in March. That's five times the previous monthly record. But for companies facing a collapse in demand, and particularly companies with stressed balance sheets, the worries are very, very obvious. So, investors were looking at taking advantage of the situation but still very cautious about doing so.
The market is attractively priced, great opportunities within markets, but a tremendous amount of stuff to get through in the short term.
Kathryn Pasqualone: Great. That's helpful, Paul. So, obviously, a lot of opportunity and runway given the drawdown, but can you talk to us about how the crisis has sort of been impacted by region? Are there opportunities in certain areas relative to others that the team is talking about?
Paul Quinsee: Yes. So as I mentioned at the beginning of the call, we are investing in all three of the world's regions. This is a truly global crisis, of course. It looked just a week or two as if this is something that was all about China, and clearly it's far from that.
I would say by region, Europe has been the worst-hit, which is partly severity of the pandemic there, partly some of the existing structural issues and slow growth, and partly just micro factors, not macro. The best performing industry throughout this has been of course technology. Seventy-five percent of the world's technology stocks are in the U.S. Europe has only 5. So the mix of industries available to you when you invest in Europe just doesn't help.
At the other end of the scale, Japan is a place where the shutdown has been less aggressive. And of course, China, ironically, given this is where the pandemic started, Chinese stocks are down around 6% year to date, thanks to an incredibly rapidly (unintelligible) response, which apparently has been effective, and also very aggressive government intervention in markets as well.
But I think over the regional differences, it's really industry that matters much more. You know, this crisis is having a very disproportionate effect on some industries and it's much more important I think to consider, whether you're looking at an energy company versus a software company, than whether the company is based in the United States or Europe or Asia. The industry dynamics are really much more important.
Kathryn Pasqualone: Great, that's helpful. One other question I had, I mean obviously we talk a lot about sustainable investing and the importance of ESG in the investment process. How did that come up during the summit? Was there a more of an emphasis on these sustainable factors or less given what's going on right now?
Paul Quinsee: That's a good question. I'm not sure it was the first thing we were talking, but I would say that advocates for the importance of so-called ESG factors would point out that, broadly, companies that have strong scores on those sorts of factors have tended to come through this crisis much more strongly than those that tend to have weak scores. I think that's partly coincidence but partly there is something really fundamental to understand there as well.
I think within the range of ESG factors, we've seen a tremendous amount of discussion on the importance of S factors, social factors, going forward. So, companies, for example, take (unintelligible) brands in China, which has been to the fore in terms of the way it treated its staff, the way its healthcare services, things like that, they clearly scored very well there, and our sense is that will be an advantage (unintelligible) some time to come. With companies that get those things wrong are probably likely to find, both their customers and their shareholders, find that harder to accept. So there's a little bit of a shifting going on I think towards the S part of the equation. Probably that's the one that has the least attention up until now. We'd much more focus on governance everywhere and the environment, particularly in Europe.
Kathryn Pasqualone: Great. Why don't we kind of switch gears a little bit and talk about the earnings picture given where we are today and the fact that a lot of companies are now reporting. There's obviously been a tremendous amount of speculation about what we're going to see. Can you talk to us about how the current environment has changed your expectations for 2020?
Paul Quinsee: Yes. We base our work on fundamental research, so in the weeks since the crisis, our analysts have been racing to adjust to the new reality, as I think I've already mentioned (unintelligible) we've never seen things change as quickly as this across so many companies and across so many industries.
So, bottom line, before the crisis, globally we were expecting earnings in the developed markets to rise by about 8% this year, to the high single digit. Now we are forecasting minus 20, so, 28 percentage points difference. We think that the public consensus itself (by) analysts are still less bad than that, it's around 11 or 12, but it's falling rapidly. The numbers in the U.S., for example, last week came down by 5 percentage points as companies started to report. So these numbers are probably still all a little bit too high, but directionally, we think that's about right.
Europe is the worst. We think earnings there are down nearly 30%. That's 35% worse than we thought before the crisis. The U.S. kind of in the middle, down around 18. And then earnings in Japan holding a little bit better, down around 12, 13. But every way you can see enormous drop.
But again, it's not so much the regions, I think it's the industry. So we think globally energy earnings are down 90% this year, basically profitability in the energy industry gets almost wiped out as we see it at the moment. Automobile manufacturing down 70%. (Unintelligible) cyclicals down 55, banks down 50, banks, due primarily of course higher provisions, but also the impact of dramatically low interest rates in the U.S. as well.
On the other hand, we've got earnings in software up this year. Healthcare earnings are going to be flat. And some of the winners, they've been reporting in recent weeks just underlie that strength. Taiwan Semiconductor Manufacturing, for example, a global powerhouse in that business, they reported about a week ago, 52% gross margin. Pretty good, they maintained that sales will grow high single digit this year. They're not changing their capital spending plans, $15 billion. A good example of a strong company getting even stronger through this.
But it's not just the short term. I think it's really important to think about what happens next, because I think markets have already begun to, as you can see in prices, look through what's going on right now, and think about next year and beyond. We do see a bounce-back next year, of course, but we still think you end up with profits in the developed world 10% to 15% below where they would have been otherwise, and that number may even be conservative.
So we don't think it's as simple as a switch being flicked, possibly to recover. And by this time next year, it's as if nothing had ever happened. We think the recovery will be slow and sometimes painful. And then we're going to move at least two or three years' worth of earnings growth across the developed markets.
And it's also important I think to really think beyond the bounce-back (unintelligible) the alphabet (unintelligible) to describe it (unintelligible) V-shaped these days, more U's or L's, whichever letter it might be, what are the longer-term changes that's come about as a result of everything that we're living through at the moment? And we've asked our analysts to think about now. They spent a week or so pulling together their thoughts, and we've collated them into three themes -- how we see consumer behavior changing, how we see corporate behavior changing, and then the government (unintelligible) environment.
And the broad summary of all of these is that we think that the impact of this crisis will be just to accelerate structural changes that were already underway and taking place. So for example, when we look at consumer behavior, obviously the whole work-from-home trend will be accelerated (unintelligible) traditional businesses, whilst nothing new, but it's dramatically accelerating at the moment, both the online specialist and then the multi-channel model, which seems to be the winner in retail right now.
On top of that, we think you have to layer in an increased consumer savings rate as people look to rebuild the damage, and then better prepare for uncertainty ahead. People obviously were shocked by what's happening and how quickly. So that's going to have an impact on many parts of the consumer business.
in the corporate world, of course, the digital transformation and shift to cloud is only going to accelerate. We think public cloud is a trillion-dollar opportunity, and we're about 20% of the way through that. We think there will be, this one's a little new, less emphasis on globalization and global supply chains. And just more broadly, a trend in which the strong are going to get stronger. Many weaker companies had sort of (propped) things up in recent years by borrowing cheaply, buying back stock. And that now looks like it's going to be very difficult to maintain.
Andy Grove, the legendary CEO of Intel, once said that, "In a crisis, weak companies are destroyed, good companies survive, and great ones get even stronger." And that's a sort of tagline for everything that we see happening playing out beyond '21 and I think that's a pretty decent way to sort of look at things.
Kathryn Pasqualone: I think that that makes a lot of sense and your comments on healthcare and software as a contrast to energy really helps to address my next question which was going to be about your views on the sectors. And it sounds like it's pretty clear winners and losers in each of those. So, maybe if we can think about, looking at this crisis relative to what happened back in 2008 and the dot-com bubble and (unintelligible) before that, can you speak to us about the mechanics of this specific crisis and how it might be different? Are there any points to note from a trading and from investing standpoint that your time is seeing? And then maybe we can talk a little bit about how the transition to the work-from-home has been for everyone, because certainly it's been an adjustment that we'd love to get any anecdotes that you have and could share with the group.
Paul Quinsee: Yes. No, I would. But I would actually like to get back, Kathryn. So we talked about the earnings, but in terms of actually deciding what to do, there's another hugely important part of all of this for investors, which is the prices that you're paying, right? So I would like if I could just take a minute on that. Because as we sat down in our quarterly meeting, and thought about attractive versus unattractive, probably the biggest question that we have to think about, and I still think the biggest question (unintelligible) right now, is how much risk to take on low-priced names.
To some investors who are just committed to owning all of the best companies, the growth companies, that's not relevant. For other strategists, the more flexible, and particular the value-based investors, thinking that through is really important. Because when we look at the markets around the world, and one of the most striking features is the gap between stocks with a high price and stocks with a low price is wider than we have ever seen, that our records go back 30 years or so, if we look at external research and some of the stuff that we get, that you can see people pulling together 100-year history of how stocks are priced (within the markets). Even then you struggled to find a time at which the gap between stocks the market likes and the stocks the market doesn't like has been as wide as it is today. It's even wider than in March of 2000, at the peak of the Internet bubble. Again, a level of differential pricing I thought we'd never see again. And yet here we are looking at it.
There's a very big difference of course between what we're looking at now and March of 2000. Back then the anomaly was that the high-priced stocks were really, really high priced. Right? So if you look at global equities, the top (unintelligible) companies on average were trading at 45 times earnings. Typically they traded more like 25 to 30. Well, within that, there were some even more extreme (unintelligible) prices. That ended very badly. Many of the companies turned out to be not that great. And when those not great businesses met a recession (unintelligible) leverage, there were some pretty epic failures and those stocks collapsed. The great opportunity for stock-pickers then was to avoid them.
That is not what we are seeing right now. The highest-priced companies look a little bit rich, but nothing exceptional. We think you pay around 30 times for the highest quintile globally versus that average of 25 to 30. There's also some incredibly good companies there, right? They've got tons of cash and they're generating tons of cash. So, just in the U.S., we take the FANG stocks and Microsoft, they generated almost $200 billion of free cash flow last year. So that is not the problem.
It's the lowest-priced stocks now that really stand out. When we looked at the lowest-priced quintile globally at the end of March, we were looking at about 6 times earnings. That's about half the usual (unintelligible) price. Since then stocks are down significantly, also the earnings have come down. But you still see enormous discount for risk and uncertainty playing out across every single market. And thinking that one through and deciding what to do, is that an opportunity or is that just a short-term risk because these companies are really, as somebody wrote in the Journal yesterday, more like call options at this point rather than stocks.
So that is where we're spending a lot of time, looking for stocks that we think are being unduly harshly treated by the market in recent weeks, perhaps not really venturing into the most dangerous part of the market, the highly-levered companies that are really facing the worst problem short term. We've certainly been willing to do the research and trying to find some (bargains) because the level of discount available is just unbelievably high.
So I thought it was worth coming back to that because actually that's sort of one of the big themes that we're talking about discussing right now in relation to whether we think clients should be looking at value strategies as well.
Now in terms of the crisis, so, managing through periods of bad markets, again, which is part of being in the equity business, I've been doing this for a while now. My first crisis was the crash of 1987, and I was six months into my career as a portfolio manager. (That clearly isn't) the business. So that was certainly a memorable one. And there had been many since then. And when I think about this crisis, it has both familiar and unfamiliar aspects to it.
So the familiar aspect of course is at a time of extreme stress in markets and the financial systems, then you must focus even more than usual on risk management across all aspects of the trading and the operational environment -- the counterparty risk, prime brokering risk, securities lending agents. All these sorts of things, you've really got to make sure you know exactly what's going on. You also have to deal with markets that are less liquid and much more expensive to trade, even at a time when you have higher volumes of equities (unintelligible) and you have to think about liquidity management too, particularly in open and advanced, if you're facing redemption.
The key to all of that of course is preparing in the good times and learning from past experiences, and then stepping up your surveillance and your sharing of ideas during the crisis itself. We've been having daily calls with our risk team across asset managers. We're having daily cross-market calls to compare notes between the different investment teams. Sharing ideas and trying to identify problems.
I would say this time we've seen very few issues from equity investors, aside from more expensive trading. Though that happens, right? So the spread of a typical name in the S&P500 went from 3 basis points in February to more than 20 basis points at one point in March, to now back down to 10, but they still remain - spreads remain elevated.
And then liquidity is down a lot as well. So (unintelligible) position sizing, running about half where it used to be. So they trade at 2% the size of the Russell 2000 (unintelligible) that 50 basis points (unintelligible) about twice normal (unintelligible) 90 basis points (unintelligible) March. It was costing more to trade U.S. small cap stocks than trading famously illiquid markets like Greece or Austria, Europe, stuff like that.
So that's been something to deal with. But the action taken by the Federal Reserve, I think also all the years that had gone into strengthening the capital division, the financial system since 2008, we haven't yet, fortunately, seen any serious counterparty issues, that kind of risk, across (unintelligible).
Also, interestingly redemptions have been very, very modest. We saw a little bit of money out in March from our open-ended funds as the sort of (unintelligible) markets. That's actually turned around recently. We've seen money coming into many parts of our business, particularly strategies like equity income and large tech growth in the U.S., our international focus strategy, global emerging markets. We've seen clients continuing to add to those. And the (float) picture has been very, very mild by past standards. We've seen many institutional clients rebalancing into equities. So that's been perhaps less of a feature than in previous crises.
But what is new of course, the health issues and the need to dramatically change the work environment. And it's hard, looking back on this, just thinking about the call, by March 23rd, in asset management, we were close to 100% of the team working out of the office in Europe and the U.S. So in seven days, we went from everybody in to more or less everybody out. Of course we had some practice in Asia that moved to a split working system about six weeks before that given the earlier appearance of the virus there.
And that need to adapt to working from home coincided with the busiest (unintelligible) we've ever had in equities. So as portfolio managers looked to mitigate risk in the early stage of downturn, we were at trading volumes running at 3 to 4 times through our desks and all of that had to be handled remotely. I think it's a testament to the incredible progress made in terms of technology that we were able to do that with minimal disruption.
The other aspect of working from home that's new, of course, is that the team never actually gets to see each other, other than at the other end of a video call and all the various options that we have for doing that. And that's working well, but we found it's important to just make sure we pay attention to the (unintelligible) things as well. So, each team has been organizing events that are supposedly a bit more fun, recognizing that working from home through a crisis is hard, it's grueling, it gets boring for people, and it can be very stressful. So, whether it's social events at the end of the week, whether it's our emerging markets team doing a daily quiz when their markets close, whatever it might be. We've done global equity town halls to make sure everyone's connected. Just trying to make sure that everyone feels connected to each other at a time when there's an awful lot going on in a very different type of reality to the ones that we're used to.
And the company too has been thinking hard about the need to look after people, to think about wellness, and make a lot of resources available for people who are having a tough time. Because of course for many people this is extremely difficult personally as well as professionally, and we're really trying to remember that. So that's the part that is new in terms dealing with this crisis and completely different to anything that we've seen before.
Kathryn Pasqualone: Yes, that's great to hear. I think we talk a lot about the increase in technology spend and it's helpful to hear that things are working as they should in the need to de-stress. So that's definitely helpful.
One other question I did have is that, you mentioned rebalancing. A lot of our clients have been very busy over the last months making those changes in shifts within the equity and fixed income portfolios. Do you have any thoughts on rebalancing, any considerations that you would highlight for this institutional audience?
Paul Quinsee: Well, I guess, people think and talk of asset allocation for a reason. A lot of thought goes into that. And I think often the best come from not deviating from it. And when markets drop sharply and the discipline tells you to rebalance, and I think typically that is the best thing to do. And then a lot of discussions with clients after 2008 as to whether or not the original asset allocations are still justified. And in the end it was and rebalancing was the right thing to do (unintelligible) markets have been strong.
From where I sit, we do think markets are going to give you decent returns. We don't really have a clue (unintelligible) remains very high. I think our portfolio managers would mostly argue that they will be surprised to see new lows but they wouldn't be surprised to see (unintelligible). And we've had some pretty spectacular gains in recent weeks. So there are a lot of different things that could happen short term.
But in terms of running a long-term asset allocation plan, I will be in favor of rebalancing in, if that weighting has dropped below wherever the target was, thanks to price action. It's not just that we think ultimately equities will recover and companies will generate enough profits to justify these sorts of prices. But it's also the returns in some of the alternatives have faded as well. So, yes, I would rebalance, and I don't think what we are seeing necessarily means a rethink of the commitment to equity.
Kathryn Pasqualone: Great. Thanks, Paul.
We hope today's call was impactful for all of you listening. And we want to thank you for your partnership. If you need any additional information on anything that was discussed today with Paul, please feel free to reach out to your JPMorgan client advisor.
I want to thank you again for participating with us. Please stay safe.
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