Global stocks have come a long way since the sharp selloff in February and March. In fact, since late March they have recovered more than half of the loss. Interestingly, this rally has taken place alongside a sharp contraction in economic activity and corporate earnings. Where do we expect equities to go from here? We see the unprecedented policy response to cushion the pandemic’s blow as key to support global equity markets–against a backdrop of historic uncertainty for activity and earnings. As a result, we still prefer an up-in-quality stance and like economies with ample policy room, as we stay neutral on global equities overall.
Global equities found their footing in late March – thanks to a swift and overwhelming fiscal and monetary policy response led by the U.S. Yet under the hood of the impressive rally lies a large dispersion in regional and style factor performance. The chart above zooms in on the sources of total return in key regional stock markets since the market troughed in late March: The U.S. and Asia ex-Japan markets have outperformed broad emerging markets, the euro area and Japan–and this aligns with our overweight in the two front-runners. An expansion of valuation multiples from cheaper levels has driven the rally across markets, even as earnings expectations contracted everywhere. Lower-for-longer interest rates mechanically increase the present value of estimated future cash flows, making equities more valuable–and relatively more attractive on a cross-asset basis.
A key feature of the equity market rally is its narrowness. The out-performance of U.S. equities so far this year is largely a function of strong gains by a handful of mega-cap technology stocks, extending a multi-year trend. The five companies with the largest market value in the S&P 500 Index account for over 20% of the index’s total market capitalization. This is the highest since the tech bubble in 2000 – and potentially a warning sign. Yet these market leaders–with businesses in e-commerce and online search – are poised for better earnings as they have strong long-term growth prospects, robust financial metrics, and business models benefiting from pandemic-spurred behavioral shifts. In contrast, cyclical sectors such as energy, financials, consumer discretionary and industrials, have reported poor earnings–and challenging outlooks.
We have seen nothing short of a policy revolution in response to the pandemic–in terms of speed, size and monetary-fiscal coordination. Measures to bridge cash flows to households and businesses through the shock should limit the cumulative economic loss over time as economies reopen, even if the recovery proves slow and uneven, in our view. Effective execution of these policies is critical, as is avoiding premature policy fatigue. And poor near-term earnings prospects mean that further equity market gains are dependent on more multiple expansion. This tilts risks to the downside, keeping us neutral on global stocks over the next six to 12 months. A re-flaring of tensions between the U.S. and China is another reason for caution. We favor credit over equities over the time horizon, given central bank asset purchases and bondholders’ preferential claim on corporate cash flows.
The bottom line
We still hold an up-in-quality stance in equities. This includes a preference for the U.S. market’s relatively high concentration of quality companies and sectors set to ride long-term structural growth trends. We also favor Asia ex-Japan on the expectation that many countries in the region, especially China, have more policy room and have demonstrated their strength in containing the virus spread. We are underweight the euro area and Japan, as they are more dependent on foreign trade and have less willingness or capacity to engage in policy stimulus. From a factor perspective, we still favor exposure to quality and minimum volatility for their relative defensiveness during periods of slowing economic activity and heightened volatility. We stay underweight value–a factor that typically fares poorly during periods of decelerating growth and has extended its under-performance of the past three years.