Q3 2020 Equity Manager Report: Special U.S. election edition
Note: For this instance of the Equity Manager Report, in addition to listing the chief tactical observations from key equity and geographic regions, we’ve also included supplemental insights on how the upcoming U.S. elections are impacting manager viewpoints around the globe.
Will 2020’s bumpy ride for equity markets continue to the end?
As the world enters the final months of a year unlike any other, the worst pandemic in modern history continues to sow uncertainty across many industries, while accelerating positive trends in others. Ultimately, until the lasting impacts of COVID-19 on the global economy are better understood, we believe elevated levels of market volatility are likely to continue. In addition, the resurgence of the virus in the U.S. and Europe, coupled with the upcoming American presidential election and final negotiations around Brexit, suggests additional whiplash in the short-term.
Amid heightened uncertainty, the third quarter of 2020 saw a continuation of the themes that have been playing out for much of the year, with a narrow group of stocks within the information technology and consumer discretionary sectors responsible for positive returns across markets. This increasing index concentration and narrow leadership created a challenging environment for equity managers, particularly in the U.S. and in global equity markets. It was a similar story in emerging markets, where the top five names—which represent over 20% of the MSCI Emerging Markets Index by weight—dominated returns.
On balance, the third quarter was difficult for U.S. large cap and global equity managers, while proving more favorable for U.S. small cap, emerging markets, Europe, UK, Japan, Canada and Australia equity managers.
Throughout the quarter, growth, momentum and quality factors continued to significantly outperform value and low-volatility factors across most regions—although value stocks experienced a short-lived bounce in September when growth stocks temporarily corrected.
Despite the fact that growth and value managers have largely held their ground, our manager insights point to an increasing disquietude in the valuations of some of the names that have performed particularly well this year. We’ve noted some concern from equity managers over whether these companies will be able to maintain the levels of growth now expected from them.
While there is a clear split in the opportunity set, we do see early signs of support for a cyclical recovery, with managers anticipating increased stimulus. Importantly, the consideration of financials—which have been at the heart of the storm—are starting to feature more prominently in our discussions with managers. One risk we do see here, however, is that lower-for-longer interest rates will continue to drive investors’ search for growth assets, underpinning valuations.
All in all, much of the way forward for equity markets still rests on the course of the pandemic. Amid this backdrop of uncertainty, we’ve tapped into our distinctive relationship with underlying managers to access the unique, forward-looking views of specialists from across the manager universe.
Near-consensus pro-cyclical views
- Nearly all managers are more optimistic about the pace and size of the economic recovery. They point to the size of fiscal and monetary policy support and their discussions with healthcare experts on COVID-19 vaccines and treatment.
- Managers are maintaining a positive tilt to sectors which benefit from increased economic activity, with an overweight to materials, industrials and energy being common. They’re also buying stocks exposed to the travel sector. In addition, they’ve further added to their bank holdings, with some managers being overweight for the first time in years.
Trimming the winners
- Increases in cyclical stocks have been funded by trimming exposures to the big miners and retailers. Most managers expect the iron ore price to normalize later this year, in addition to retail sales, which benefitted fromstay-at-home orders.
Growth managers positioned for higher activity
- Managers continue to see opportunity in the COVID-durable businesses within industrials and consumer discretionary.
- With profitability increasing for gold miners, managers are closing underweights to the sector and are upbeat on gold.
- Managers expect elevated levels of volatility to continue throughout the fourth quarter and into 2021, due to the U.S. elections and ongoing pandemic risks, and are looking to take advantage of price dislocations.
Value managers cautious about risks
- Few managers are adding to energy. Those doing so are focusing on quality, following dividend cuts in the sector.
- Value managers remain confident on less-cyclical sectors, including financials, consumer staples and utilities, as uncertainty stemming from the U.S. elections, trade tensions and the pandemic persists.
Emerging markets equities
Robust recovery in Chinese GDP (gross domestic product) growth
- Managers see North Asia as best positioned for recovery opportunities in cyclical renormalization, e.g., local tourism, property and autos. Fiscal stimulus and increased infrastructure spending are supportive for a value rebound, e.g., financials and materials.
- The weakening U.S. dollar remains positive for emerging-markets carry currencies.
Strategic beneficiaries of geopolitical movements
- Chinese hardware suppliers and national champions gain market share as substitutes in the global tech supply chain.
- Opportunities also abound in A-share/Hong Kong re-listings.
Earnings acceleration and initial public offering (IPO) prospects
- Earnings growth is driving continued conviction in internet businesses with scalable digital moats and consumer penetration, e.g., ecommerce, digital payment, ecosystems and food delivery.
- Attention on rich pipeline of IPOs in China and elsewhere.
U.S. election insights
Emerging markets (EM) tailwinds
- The current economic environment—with unprecedented levels of fiscal stimulus, low interest rates and higher inflation—represents a favorable backdrop for EM assets. This is unlikely to change regardless of who wins the election.
Sino-U.S. trade war
- While rhetoric is not expected to be reversed, a win by U.S. presidential nominee Joe Biden is expected to result in a more measured and less punitive approach toward China—particularly in regard to new tariffs and sanctions. A more inclusive approach with partnering nations is also anticipated if Biden wins. Regardless of the outcome, both the Republican and Democratic parties will likely continue to push for less reliance on China in the supply chain.
Continued U.S. dollar weakness
- This trend is expected regardless of whether Donald Trump or Joe Biden wins the election, but is potentially more likely if Biden prevails. A weaker dollar is supportive for EM equities. Some managers are increasing exposure to EM high-carry currencies which have stabilized and look particularly cheap, such as the Brazilian real and the Indian rupee.
Increased stimulus and infrastructure spend
- This is broadly expected under a Democratic clean sweep, which would be beneficial for commodity exporting economies and EM broadly. Overall, such a sweep would also likely be supportive for a cyclical/value recovery.
- COVID-19 is limiting risk-taking ahead of the U.S. elections despite positive signals. Normalization in this regard would be much more supportive to markets than the election outcome.
Europe and UK equities
Brexit volatility is back
- Renewed fears have weighed on sentiment, and the general belief is that any conclusion is better than further stalling.
- Overall, investors remain underweight the UK. However, some managers have begun to reduce this position.
Increasing mergers and acquisitions (M&A) as UK valuation spreads widen
- Renewed M&A interest from overseas firms in UK-quoted companies.
- In the case of a harder Brexit and a collapse in pound sterling (GBP), we would expect flows into the UK market and further M&A.
European green deal to inject up to €7 trillion
- This provides opportunities for polluting and high-carbon-emitting companies that are positioned to take advantage.
- These are mainly in the value sectors of the market, creating opportunity for value-biased portfolios (if rebalanced toward the green winners).
U.S. election insights
U.S. election taking third place behind COVID-19 pandemic and lead-up to final Brexit deal
- However, managers are mindful it may create temporary volatility in certain sectors.
Tax and multinationals
- A Democratic win is likely to increase corporate taxes in the U.S. This would reduce corporate profits and be a negative for those UK and European companies with American subsidiaries.
- Regardless of whether the outcome favors Democrats or Republicans, budgets for defense companies are likely to stay flat. Holdings in the likes of BAE, Serco and Qinetiq could provide exposure to steady growth.
Green new deal
- A Biden win could accelerate the decarbonization agenda, with restrictions on oil and gas exploration and investment in renewable energy. Near-term, it’s more complicated, given the COVID-19 demand shock this year as well as the UK/Europe having more developed policies.
Global and international equities
Managers position for a cyclical rally
- Managers have added to cyclical laggards and well-positioned, pandemic-pressured stocks in anticipation of a recovery. Increased stimulus under a Biden presidency would benefit economically sensitive names and, possibly, lend upward pressure to interest rates. This would benefit value opportunities and financials in particular.
The winners and losers of extended work-from-home
- Commuter-dependent businesses and commercial real estate face headwinds. Managers are instead backing industries that enable digital capabilities, such as enterprise software, data centers, cell towers and online banking trends.
M&A is picking up after a pandemic-related pause
- Consolidation accelerated in numerous sectors, prompting renewed focus on governance and balance-sheet strength.
U.S. election insights
- If Biden wins the presidency, managers anticipate that higher corporate taxes, especially foreign income tax, will negatively impact S&P earnings and foreign technology income. Overall, tax policies under a Biden administration could be a headwind for aggregate supply growth.
- On the other hand, spending priorities under a Biden administration could be a tailwind for aggregate demand in the economy. For example, Biden’s proposed infrastructure spending plan would benefit industrials, materials and other construction-related industries.
Impact on the healthcare industry
- Both Trump and Biden have expressed intentions to control pharmaceutical pricing, but managers do not expect a reshaping of the broader healthcare landscape. Biden, as one of the architects of the Affordable Care Act (ACA), is not expected to make meaningful changes to the statute should he win the presidency.
Mixed message from growth managers
- Many managers maintained the overall shape of portfolios, expecting growth stocks— particularly, beneficiaries of digitalization and/or electric-vehicle (EV) expansion—to continue to structurally grow.
- Concerns surrounding small cap stocks, which appeared to be overbought by retail investors, remain.
Market-oriented managers trimming outperformers
- While maintaining barbell portfolios, more market-oriented managers started to trim positions in stocks with stretched valuations.
- Managers are biding their time to re-enter beaten-down sectors.
Value managers diversifying alpha source
- Due to the continuous underperformance of value, many managers are attempting to diversify their sector exposures, given increased correlations and the risk this environment continues.
- Reductions in some auto-related names on the back of an increasing threat of acceleration toward EV.
U.S. election insights
- Initial views that a Democratic victory would lead to an increase in corporate taxes—and thus, negative connotations for the stock market—are no longer as prevalent. Instead, managers are focusing on the positive market impact that could come with increased public spending if Biden winds the presidency.
- As such, there’s greater emphasis on dissecting public spending to understand which industries and sectors are most likely to benefit, i.e., renewable energy supply chains, which would benefit from a Green New Deal.
Real assets equities
- Within listed real estate and infrastructure, the new economy sectors are viewed as strategic components when constructing portfolios. These sectors are valued on their ability to generate long-term cash flow growth, and the stability of those cash flows.
- New economy sectors include utilities that focus on renewable energy (which are well-positioned in a global decarbonization world), tech sectors (cell towers and data centers, which are vital communication links) and transportation/logistics sectors (freight rail, ports, toll roads and warehouses, which provide the physical network for moving goods) where growth is driven by ecommerce and the need to increase efficiency.
- At risk sectors include mid-stream energy pipelines, which are viewed to be losing market share to renewable energy. These sectors may provide some tactical opportunities in the short-run but are facing significant long-term headwinds.
U.S. election insights
Focus on climate change
- A Trump re-election will likely cause short-term volatility in the clean energy and lithium sectors. If Biden wins, and the Democrats secure both the presidency and the House of Representatives, clean energy companies could pop considerably, as improvements in climate change initiatives are likely to unfold.
- These stocks have already run well in 2020, but they were extremely cheap at the start of the year. Some managers believe they would still be cheap even if they went up 100% from here.
- The new U.S. president will likely be able to pass a more robust fiscal stimulus package, supportive of consumer spending and residential demand. However, there will likely need to be some regulatory changes in order to address the government’s increased borrowing—possibly through a tax increase.
- If Biden wins, core urban areas may see an easier road ahead. Mass-transit-dependent cities, such as Manhattan, are facing a tremendous revenue problem due to steep drops in ridership. These cities are likely to receive more federal assistance from Biden rather than Trump.
U.S. large cap equities
Tech and healthcare
- While growth managers remain optimistic about earnings prospects for tech stocks, they have become more attentive to high valuations. Managers have been reducing exposure in mid cap tech stocks more than their large cap counterparts, with valuations even more extended in this segment.
- Most managers are cautiously optimistic about healthcare stocks coming out of the election, particularly those related to elective procedures that should rebound after the COVID-19 crisis fades.
- Banks are being featured more prominently in value portfolios, as managers believe conservative reserves and attractive valuations create a good entry point.
- Managers acknowledge that M&A activity has been held back due to COVID-19-related regulatory slowdowns, as well as the difficulty evaluating acquisition targets with dramatically reduced revenues. Managers expect momentum in M&A activity to pick up early in 2021.
U.S. election insights
Focus on bottom-up
- Despite managers generally expecting a Biden win, few are purposely positioning their portfolio toward industries that are likely to benefit.
Impact on healthcare
- A Democratic sweep of both the presidency and Congress could result in an expansion of nationalized health services. Alternatively, a Republican sweep could potentially result in overturning the ACA. Since these scenarios are on the less probable side of election outcomes, managers are not meaningfully adjusting their positions in healthcare providers and services.
Impact of weaker U.S. dollar
- Investors expect the dollar to weaken if Biden wins the presidency, which would benefit commodity-based stocks as well as other stocks in industrials, consumer products and technology with non-U.S. revenues.
U.S. small cap equities
Growth managers begin rotating into quality cyclicals
- With technology sector valuations at record highs, small cap growth managers have gradually begun rotating into quality cyclicals within financials and industrials.
Value managers nibble at discounted banks
- After underperforming the broad market during the quarter, banks have gained the attention of value managers. Cheap valuations, less-than-expected loan losses and stronger, better capitalized balance sheets have drawn managers to incrementally add back to regional banks.
Small caps ready for prime time
- The small cap Russell 2000® Index is at its relatively cheapest level to the large cap Russell 1000® Index in 17 years. Small cap managers expect their asset class to outperform in a post-COVID recovery, similar to the outperformance seen in 2010 following the Global Financial Crisis.
U.S. election insights
Most favorable election outcome for small caps
- A Democratic sweep is likely to drive a larger stimulus of the economy and favor small cap business models that are largely domestic. Small caps are less likely to be valued on near-term earnings, which would minimize the impact of any adverse tax changes. In the event of a Democratic sweep, small cap internet stocks could be relative beneficiaries, as the threat of breaking up the larger FAANG companies would likely become greater.
The bottom line
Persistent uncertainty over the pandemic, in addition to the U.S. elections and Brexit negotiations, likely spells persistent volatility for equity markets in 2020’s waning months. During these turbulent times, we believe paying close attention to the views of specialist managers is critical to assessing potential opportunities for outperformance. We remain firmly committed to keeping you apprised of all the latest insights from across the manager universe.