Q4 2020 Equity Manager Report: Value the clear winner in most regions
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 manager insights on the outlook for 2021.
Is the tide turning for value managers?
While 2021 has started not unlike how much of 2020 played out, with COVID-19 infections continuing to spread and many countries reimplementing lockdown measures, the approval and rollout of various vaccines to combat the coronavirus has been an undeniable game changer for markets. It's provided a clearer road map for a return to some form of normalcy, although the path ahead is still likely to remain bumpy, with continued uncertainties in the offing.
Positive COVID-19 vaccine news sparked a clear rotation to more cyclical areas of the market across most regions during the fourth quarter of 2020. This marked a near-complete reversal from the prior three quarters of last year - where narrow market leadership within the information technology and consumer discretionary sectors dominated index returns - leading to a risk-on environment.
The broadening of opportunities created a more favourable environment for most managers, particularly for global equity, emerging markets, U.S. large cap, Europe, UK, Japan, Canada and Australia equity managers. Conversely, the fourth quarter presented a challenging environment for U.S. small cap and real asset equity managers.
The value factor in particular was the clear winner across most regions, with small cap also performing well. Conversely, momentum and low-volatility were the main laggards as a result of the transition to a risk-on environment.
Growth - which was the standout factor throughout most of 2020 - continued to perform well in some regions, highlighting that conviction in long-term drivers of the market remains intact for now. Even though there has been some profit-taking in companies that benefited from the shift to an online environment, most managers agree that the trend toward ecommerce and remote working is here to stay - and expect any recent pullbacks to be short-lived.
As the cyclical rotation gathered pace during the fourth quarter - alongside expectations of a reflationary environment - many managers became more constructive on the banking sector, which was one of the hardest-hit areas at the outset of the pandemic. Amid these expectations, managers increasingly rotated into banks that appeared to have overprovisioned during the downturn, but look fundamentally robust and are set to benefit from any steepening of yield curves.
The conclusion of the U.S. elections with a Democratic clean sweep and the year-end post-Brexit trade deal have also helped to boost market sentiment - and with it, the potential for additional recovery - as the calendar stretches further into 2021. However, until the pandemic is truly behind us, the road ahead will likely remain bumpy. With this in mind, we've turned to the unique, forward-looking views provided by our distinctive relationship with underlying managers for insights on the year ahead.
Pro-cyclical positioning maintained
- Nearly all managers remain positive on the outlook for the global economy. Managers are maintaining a positive tilt to sectors which benefit from increased economic activity, with an overweight to materials, industrials and energy being common.
Banks less disliked
- Managers are becoming more constructive on the Big 4 banks, with some now being slightly overweight on selected names. Cyclical tailwinds, potential for provision write-backs and the resumption of dividends are reasons given for adding to the banks.
China restrictions not a concern
- Few managers have raised China placing restrictions on some of Australia’s exports as an investment issue. This is because it hasn’t applied to iron ore and is expected to resolve for other exports over the medium-term.
EV and sustainable energy
- The continued growth in electric vehicles (EV) as well as the green agenda is expected to generate increased demand for electric battery inputs, favouring Australian lithium and rare earth miners. Managers are closely monitoring opportunities and valuations in this space.
- The global recovery is expected to drive strong demand for materials. However, managers are concerned with pricing pressure for iron ore due to the increasing Brazilian supply.
Views on oil continue to be mixed
- With the reopening trade in mind, value managers are bullish on oil stocks, with a preference for more price-sensitive exploration and production (E&P) names, while remaining underweight pipelines. Growth managers are more reluctant, citing environmental, social and governance (ESG) risks.
Recovery trade opportunities
- Reopening trade opportunities with a cyclical bend are the focus for managers heading into the new year, amid the vaccine rollout and expectations of strong consumer spending. In addition to energy, selected real estate sectors and cyclical stocks are viewed as opportunistic.
M&A views: Stealing lunch money from the year 3 students
- Managers have been unsatisfied with recent acquisitions falling below intrinsic value estimates. While acquisitions have been at a premium to market, managers have voted against several proposals in hopes of reaching fair values.
Emerging markets equities
Vaccine news injects risk-on appetite
- Managers are rotating into banks that look fundamentally strong due to overprovisioning. The prospects for an improving credit cycle have also triggered more optimism.
- Managers see potential cyclical entry points - post-kitchen-sinking of earnings - within materials (cement), industrials and travel/tourism.
Rotation from expensive to cheap gathers pace
- Profit-taking in high momentum areas such as Chinese internet, consumer discretionary and healthcare.
- Oversold markets, such as India, are seeing renewed interest - including those with undervalued currencies (i.e., Brazil, Russia).
- Demand recovery will benefit energy/commodity names.
Renewable energy becoming a greater focus
- The shift to new technologies and alternative energy is gathering fundamental and political momentum across EV batteries, wind/solar energy, fuel-cell technology, chemicals and recycling/packaging.
- China-U.S. tensions are expected to ease under U.S. President Joe Biden’s administration, though unlikely to unwind in the near-term. Export controls, entity lists and other measures will likely be more targeted for national security reasons, rather than the broad-based approach seen under the administration of former President Donald Trump. Managers are sanguine about improved cooperation as both countries seek to maintain trade relations.
- Emerging markets and global managers continue to see a growing opportunity in China’s emboldened moves to decouple certain areas of the supply chain. This has led to import substitution across component makers (chips, boards, sensors and capacitors). At the same time, the indispensable nature and leadership of some businesses, such as semiconductors, are underscored.
- Managers cite China’s early economic recovery, accelerating consumer spending and expectations for high single-digit GDP (gross domestic product) growth as drivers of attractive opportunities in the country.
Potential regulatory headwinds for large tech
- China’s large tech firms have come under scrutiny on anti-monopolistic rules within their ecosystems, resulting in fines issued to several internet darlings. Ant Group’s IPO (initial public offering) was halted over banking regulations. However, given the importance of China’s digital economy and digital infrastructure, investors remain benign toward risk of excessive intervention.
Opportunities beyond China
- In the shorter-term, managers are increasingly looking at opportunities outside of China that have yet to benefit from a post-COVID-19 recovery, given their inability and/or ineffectiveness at controlling the spread of the virus. These types of markets, including India, Brazil and South Africa, remain oversold.
- Increased infrastructure spending globally, as well as a pick-up in travel, will also benefit commodity and energy producing economies.
- Most managers and economists remain of this viewpoint, which is typically supportive for emerging markets. Managers continue to selectively increase exposure to countries with relatively cheaper currencies, such as Brazil, Russia and Mexico.
U.S. dollar weakness expected to continue
Europe and UK equities
- The post-Brexit trade deal creates positive sentiment in the UK markets and is a potential tailwind for stronger performance in 2021. Managers are looking closely for opportunities in banks, supermarkets and oil and gas sectors.
- While rising COVID-19 infections saw many European countries tighten restrictions, the positive vaccine news created a cyclical rebound. Managers are retaining or increasing their cyclical exposure given the more favourable outlook.
IPO activity returns in UK markets
- IPO activity saw a significant uptick during the fourth quarter. IPOs are predicted to increase through 2021, especially in biotech and fintech. Some managers are looking at these as the new structural growth stories, with more traditional growth stocks at stretched valuations.
Brexit deal a tailwind for strong UK 2021 performance
- The underperformance of the UK versus other regions has largely been driven by the risks and uncertainty of a no-deal scenario, which has been, to some extent, removed with the recent post-Brexit trade deal. The initial reaction to the deal has been positive for the FTSE All-Share Index, as the worst-case scenario has been avoided. UK domestic stocks have already rallied strongly but the market remains relatively undervalued compared to other regions. Managers are looking for opportunities in banks, supermarkets, and oil and gas.
Quick out of the blocks with vaccine rollout
- The region is unlikely to face the same kinds of concerns about access and distribution of vaccines, as is the case in many other parts of the world. UK and European Union (EU) member states will benefit from advanced purchase agreements with pharmaceutical producers, and the expectation is for high-priority groups to be vaccinated by the end of the second quarter.
- Strong policy support and robust balance sheets have limited the scarring effects of the COVID-19 crisis so far, and expectations are that activity will begin to recover from the second quarter onward, with output converging more quickly with its pre-virus growth path thereafter.
Inflation to ease markedly in Europe, shift to policy normalisation will wait
- Additional costs associated with the crisis, supply-side constraints due to lockdown measures and a lack of disinflationary pressures in certain labour-intensive services kept core inflation close to multi-year highs for most of 2020. Investors expect central banks to start normalising policy toward the end of 2021 or beginning of 2022.
- A recovery in labour markets, large inflows of EU funds to support investment projects and the spill-over effects of the eurozone recovery on exports mean that output gaps are likely to become smaller by the end of 2022. Inflationary pressures will likely follow.
European Green Deal
- The European Green Deal is the most ambitious decarbonisation plan globally and would represent an estimated €10 trillion investment in public and private investments by 2050. These investments will primarily be focused on carbon-intensive industries, such as transport, power generation, manufacturing and heating. Managers continue to look for opportunities in the various sectors that are set to benefit.
Global and international equities
Financials led in Q4, value managers see more gains
- Banks stocks are gaining as credit losses prove lower than feared and the yield curve steepens.
Electric vehicle stocks remain in focus
- Runaway share prices for the best-known companies have pushed investors to look at the EV supply chain for exposure to this theme. Managers believe that competition from Chinese and German automakers will benefit affordability and model offerings.
Crude oil and energy companies are on a path to recovery
- Energy fell to just 3% of the MSCI All Country World Index last year. U.S. small cap energy showed the biggest gains in the fourth quarter, but companies that right-sized stand to exhibit a sustained rebound.
Cloud company valuations lofty, but silicon is on the run
- Semiconductor companies rallied, as holders argue that they will benefit from consolidation and capacity shortages even as demand for work-from-home equipment levels off.
Growth managers trimming expensive stocks
- Many managers trimmed strong performers, especially in the small cap area, while maintaining the overall shape of their portfolios with exposure to continued growth areas, such as tech, EV and online.
- While a value recovery is expected in the short-term, most see the structural growth plays to be more sustainable.
Value managers maintaining existing holdings
- Value managers maintained overall positioning. Although financials rose in other developed markets, performance of Japanese financials has remained subdued, given low expectations of a rise in interest rates.
Market-oriented managers adding cyclical exposures
- These managers added laggard cyclicals, given the expectations of a strong near-term economic recovery from pent-up demand.
- Some managers continue to selectively add to companies exposed to EV or new energy themes.
Real assets equities
New economy sectors viewed as strategically important
- Real estate, industrial, single-family housing and cell towers are benefitting from long-term structural changes, due to their ability to generate long-term sustainable cash flow growth.
- In infrastructure, utilities focusing on renewable energy are well-positioned in a global decarbonisation world. This is because the tech sectors (cell towers and data centres) are vital communication links, while the transportation/logistics sectors (freight rail, ports, toll roads and warehouses) provide the physical network for moving goods where growth is driven by e-commerce.
- Conversely, mid-stream energy pipelines are losing market share to renewable energy, but may provide some tactical opportunities in the short-run.
- Perceived market-positive U.S. election results and vaccine news created a market where deep value stocks rallied quickly. The names that suffered the most due to the pandemic bounced back quickly in the fourth quarter, while the stable sectors pulled back.
- Managers are reluctant to materially buy into the hope trade - where value will outperform - especially in the office and hotel sectors. The office sector faces structural headwinds, and the impact of decreasing demand from business travel is yet to be determined. While deep value stocks may outperform over the short-term, they are also the ones facing structural headwinds over the long-term. Managers are being tested on whether they will capitulate or hold their ground. At the margin, most managers are adding risk to their portfolios after being caught out too far on the defensive spectrum.
- The market continues to look through Brexit, which is arguably in the rear-view. The additional cost of doing business in the UK is a net negative in terms of long-term growth, and is an area that managers continue to evaluate.
U.S. large cap equities
- Despite the low interest environment, value and market-oriented managers are optimistic about opportunities in the financial sector. The steepening of the yield curve is improving the outlook for bank stocks in particular.
- Value managers are starting to look at ideas in the utilities sector, as the group has lagged the broad market.
- Growth-oriented managers are positioning for a recovery trade as the nation begins to emerge from the COVID-19 pandemic. Managers have been shifting to take advantage of opportunities in the consumer discretionary sector.
- Managers are also seeing opportunities in healthcare stocks, particularly medical technology and device stocks that will benefit from a resurgence in elective medical procedures.
- Although both political parties are vocal about risks related to big tech - including social polarisation and monopolistic industry structures - managers question the materiality of potential regulatory risk. While some managers have begun to include regulation-based scenarios in their valuation models, they do not perceive the risk to be highly impactful at this point, and managers who own the stocks continue to be optimistic.
Finding common ground
- Managers expect a few sectors to enjoy bipartisan support, such as infrastructure spending in areas like highways, transit, airport, water and sewer projects. In their outlook for 2021, many are drawing comparisons to the strong market rally and active management outperformance of 2009-10 and 2016-17, which were driven by a commodities reflation backdrop.
- Despite the outcome of the elections, managers believe that additional healthcare regulation will be limited in scope. As a result, they’re optimistic about several segments in the healthcare sector. After a difficult fourth quarter, many managers are seeing opportunities among medical technology and device companies, as well as healthcare services. However, they continue to be cautious about pharmaceuticals, given the possibility for drug-price reform.
U.S. small cap equities
Growth managers begin rotating into quality cyclicals
- With technology sector valuations at record highs, small cap growth managers have been rotating into quality cyclicals within financials and industrials. Some expect a near-term pullback in markets.
Value managers favour financials and consumer stocks
- As the economic outlook improves, value managers see opportunity in banks and insurance, due to the expectation of higher interest rates. They’re also seeing opportunities in more challenged consumer areas, such as travel and leisure companies.
Early stage of a sustained recovery in small cap value
- Value managers maintain confidence that small cap value stocks should lead the broad market as the U.S. economy recovers. Growth managers are also recognising the opportunity in attractively valued cyclical growth companies, when compared to secular growth companies.
Risk assets and normalisation
- The Biden administration is expected to facilitate a substantial increase in fiscal support for the economy. This would be supportive of risk assets over the coming year.
- In addition, policy changes on taxes and the minimum wage are likely to benefit the working and middle classes, at the expense of corporate earnings. Stronger U.S. household balance sheets - a result of lower mortgage rates and credit card balances during 2020 - further set the stage for an atypical acceleration in spending once lockdowns are lifted.
The bottom line
The slew of positive vaccine news late last year was the primary catalyst behind the pronounced rotation into more cyclical areas of the market. Amid the prospects of a broader economic recovery in 2021, we expect that a risk-on environment will continue to prevail in the months ahead. In such an environment, there will be no shortage of opportunities and risks - and we believe the views of specialist managers will be critical to exploiting both. We look forward to keeping you apprised of the latest insights from across the manager universe as the world looks ahead to brighter times.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.