European equities: Sharp sell-off in October
A deteriorating COVID backdrop weighed on risk sentiment throughout the month and the European equity market sold off sharply in October. The last week of the month was the worst week for European equities since March. Moreover, investors were starting to get more nervous about the presidential elections in the US, as the race to the White House intensified, and about the outcome, with its potential impact on equity holdings. China-US relations were still pretty tense. The Brexit saga added another layer of risk.
However, equity markets recovered in early November following the election of Joe Biden and the publication of the phase-3 results for Pfizer's COVID vaccine. Biden should strengthen international cooperation and bring the US back into the Paris agreements, which should, in turn, act as another catalyst for European equities, especially on "Value" stocks and companies offering solutions that fight climate change.
By the end of the month, all the major economies in the region were recording record daily cases. Policymakers, seeking to balance economics with virus control, initially adopted a series of local lockdowns. Yet, as the month progressed, several major governments, including Spain, France, Germany and Italy, were forced to adopt national level restrictions.
All of the major economies in the euro area will benefit from the ongoing labour market support. However, this has not been enough to prevent a deteriorating consumer outlook: the increase in infections and restrictions has impacted sentiment, with consumer confidence falling. Equally of concern is the increase in the eurozone unemployment rate, which has risen to 8.3%.
The new lockdown measures should slightly worsen our economic outlook for Europe. However, we remain confident about the economic recovery. Between now and 2022, most sectors in Europe, except for the Energy and Real Estate sectors, will see an increase in earnings compared to 2019 (3Y EPS Growth 20-22e).
Valuations are high in Europe, close to pre-COVID-19 levels, as most of the sectors are negotiating above their average 12M Fwd P/E. Only the financial sector is below its historical average.
There are early signs of deterioration in the EU macro backdrop. The rising number of infections/tighter restrictions were starting to have an impact on mobility trends, which showed a rollover across most of the region. Labour market indicators across many countries started to deteriorate, too, and consumer spending in Germany fell by the most in 4 months.
The manufacturing PMI showed continued strength (Eurozone October Manufacturing PMI was 54.8, vs a flash reading of 54.4 and a September reading of 53.7), the services PMI declined further (the euro zone services PMI fell to 46.2 in October, from September’s 48). The continued PMI resilience is likely a reflection of re-stocking.
In terms of sectors, Energy, Financials and Consumer Discretionary outperformed. The announcement of Pfizer’s interim vaccine results surpassed our expectations. The market responded with a violent rotation away from Growth and Stay-At-Home stocks towards Value and Back-to-Work stocks. On the other hand, in line with this violent rotation, Information Technology underperformed.
Value, another false dawn? Value has been underperforming since 2018 in Europe. However, this underperformance must be viewed in the context of a broad-based decline in economic momentum, started by China’s deleveraging cycle in 2018, and continued by Donald Trump’s trade war in 2019. In addition, the potential for a strong rotation at the beginning of 2020 was demolished by another deflationary destocking event: COVID-19.
US 10-year yields and PMIs have both been in a broadly downward trajectory since 2018. And, since the lows of the COVID crisis, while PMIs have recovered, bond yields haven’t, with investors still sceptical about the sustainability of the recovery in the face of additional COVID waves (such as what we have been enduring in Europe and, now, in the US as well). This is why the vaccine is critical – it helps provide a realistic endpoint to COVID uncertainty. Consumers have been patiently accumulating savings to unleash in a less COVID-afflicted world. This is why we should soon be in a PMI upcycle that should last well into 2021. The gap between yields and data should start to compress.
Every crisis has a moment which marks the beginning of its end, be it Bernanke’s QE in 2008, Draghi’s “whatever it takes” in 2012, China’s re-leveraging in 2016 or the Fed’s U-turn in 2019. If the vaccine news is the first step towards resolving COVID, we suspect the rotation has further to run. And investors do not appear positioned for it.
As a result, we increased our grade on Insurance to +1 from 0, as the sector is now more attractive and especially as long-term interest rates are rising.
We decreased our grade on Utilities to -2 from -1, as it is a very expensive defensive sector with a very high debt level. In addition, high sector sensitivity to tensions regarding long interest rates is ongoing.
We are keeping our strong overweight on high-quality Retail Banks, as they offer an excellent risk/reward level. In addition, the new vaccine should allow the economy to normalize and the US and European rates to rise.
We are keeping our Neutral grade on Household & Personal Care, as this sector has limited upside, given the recent outperformance and its high sensitivity to interest rates. However, in our view, the sector remains a long-term winner.
We are keeping our negative grade (-1) on Communication Services, because of challenging fundamentals (negative growth and declining margins).
US Equities: Major US stocks in the red
US equity markets underperformed, with major indices – driven by a Tech sell-off during the last week of the month – falling in October. In addition, US daily coronavirus cases increased throughout October to 81,000 per day. The mid-west is now bearing the brunt of the new infections. Throughout most of October, markets seemed to move closely in line with US fiscal stimulus-related news. While there were (many) glimmers of hope on this front, in the end no stimulus materialized. The lack of a pre-election stimulus was a big overhang on market sentiment, especially as the likelihood of a package – coinciding with the tighter social restrictions announced across Europe – dimmed in the last week of October.
However, equity markets recovered in early November, following the election of Joe Biden and the publication of phase-3 results for Pfizer's COVID vaccine. The presidential elections are now over and Congress will now be able to consider the adoption of a new recovery plan. The US is very likely to need a new fiscal package in the coming month to withdraw from this crisis.
Joe Biden is now President-elect and Donald Trump will leave the White House on January 20. Trump, however, has not yet conceded and his team is challenging votes in many states. Democrats should keep a majority in the House, but a thinner one, while the party holding the majority in the Senate might be known only in January. The lame-duck Congress could agree on a short-term, medium-sized, fiscal package; if not, it should at least vote a continuing resolution before December 11.
The number of COVID-19 cases is increasing. Hospitalizations and ICU-utilization are both rising and, while there is currently still spare capacity, there is now cause for concern that current activity levels will place too great a burden on the system over the winter months. The increase in cases has not so far impeded the reopening of the US economy, with 29 states now fully reopen. Activity data in the five most populous states have increased slightly over the month, but are still 30% below last year’s level.
GDP should contract by 3.8% in 2020 and increase by 5.2% in 2021. However, our central scenario assumes additional fiscal support and a gradual end to social distancing. Without such support, activity growth will be weaker in 2021.
Activity has recovered quickly, rebounding at a more-than-30% annual rate in Q3. The recovery, in addition, continued until the beginning of November .
The impact of the COVID-19 crisis on earnings will be quickly erased, as demonstrated by 2021 vs 2019 (20-22e) earnings. However, the Energy, Real Estate and Financial sectors will remain largely below their 2019 earnings.
Valuations are high in the US, as most of the sectors are negociating above their average 12M Fwd P/E. Only the healthcare and financial sectors are below their historical average.
In terms of sectors, Energy and Financials outperformed, with news flow around the vaccine and Biden victory triggering a market rotation, due to the valuation extremes in Growth vs. Value. Consumer Staples underperformed.
The announcement of Pfizer’s interim vaccine results surpassed our expectations. The market responded with a violent rotation away from Growth and Stay-At-Home stocks towards Value and Back-to-Work stocks. The US momentum factor had its worst ever day of performance since 2002, while the US and EU Value factor had one of its best days. Banks had their second-best day ever.
There will be zigs and zags. In the near term, investors will have to deal with poor lockdown-driven data, and there are several unresolved questions around vaccine efficacy and distribution. However, every crisis has a seminal moment marking the beginning of its end, be it Bernanke’s QE in 2008, Draghi’s “whatever it takes” in 2012, China’s re-leveraging in 2016 or the Fed’s U-turn in 2019. If yesterday’s vaccine news is the first step towards resolving COVID, we suspect the rotation has further to run.
As a result, we increased our grade on Banks from +1 to +2, as the new vaccine should allow the economy to normalize. Moreover, the American 10y treasury yield is now constructive for the sector.
We are keeping our neutral grade on Media/Entertainment, as Biden could raise taxes on these companies. This sector should also suffer from the normalization of the economy as investors position their portfolios to “Back-to-Work” instead of “Stay-at-home” stocks.
We are keeping our overweight on Technology, despite the recent downtrend, as fundamentals remain solid with secular growth drivers.
We are keeping our neutral grade on Consumer Discretionary. The upside is now limited on specific names. Moreover, it is a very heterogeneous sector, with companies like Amazon dominating and many losers. On the other hand, the vaccine could change the situation and favour “reopening-economy" stocks. Investing in this sector has required good stock-picking skills.
We are keeping our neutral grade on Industrials, as the sector has limited upside, given the recent outperformance and relatively expensive valuation at current levels.
Finally, we are keeping our positive exposure to Healthcare, given its decent valuations (especially from a historical perspective) and resilience in the current COVID-19-driven economic slowdown. It is almost sure now that the Senate will remain under Republican control while the Presidency goes to Joe Biden. This outcome was our main assumption and, as such, presages a good outcome for the healthcare sector. Joe Biden has a healthcare agenda but is a politician with moderate views who favours consultation, while a split Congress makes drastic changes virtually impossible.
Emerging Markets: Suddenly, hope.
Following a period of some consolidation in September, October – supported by fiscal and monetary stimulus and improving economic data – started off in a positive mood for global and emerging markets. However, sentiment turned cautious, as a second wave of COVID-19 hit Europe and the US (even President Trump), forcing some new confinement initiatives.
Metal prices and clean-energy stocks held up well (with many investment initiatives expected worldwide) and oil prices strongly corrected (on expectations of lower COVID-driven demand and increased supply, not least from Libya). In this environment, markets saw a clear performance divergence, with developed markets (-3% in USD) strongly underperforming EMs (+2%), more in particular Asia ex-Japan (+2.8%).
YTD, emerging markets are now outperforming developed markets. Asia was strong, with China – driven by strong economic data, hardly existing COVID, the expected huge ANT Finance IPO and the coming 5-year plan – strongly up.
Korea, Taiwan and India remained slightly positive, while some ASEAN markets (especially Indonesia and the Philippines) finally showed some catching-up, although Thailand, suffering from political tensions, did not.
EMEA and Latam kept the EM asset class from performing better, with both regions ending in negative territory and markets like Russia, Poland and, especially, Turkey, suffering strongly.
Most sectors ended positive, with exceptions including Energy, which lost heavily on the oil-price correction and on falling (short- and long-term) demand expectations.
The election of Joe Biden, which should strengthen international cooperation, should, in turn, have a positive impact on Emerging Markets.
As a result, we increased our grade on banks to neutral, as they offer an excellent risk/reward level. In addition, the new vaccine should allow the economy to normalize and US and European rates to rise.
Within Consumer Discretionary, although there is the potential for upgrade on Automobile, given the news regarding the vaccine and ongoing value run, there is hesitancy following the recent strong performance.
We increased our grade from Neutral to +1 on Latin America, as this a typical region with high bombed-out value and cyclical content (financials, energy, commodities). The ongoing Value rally should benefit the region.
We are keeping our grade on transportation, as valuations are attractive. Stocks, severely punished, are likely to recover on the back of the reopening/vaccine. As Risk/reward is clearly on the upside, re-opening the potential for a rally.We continued to keep a balanced portfolio, taking some profit on strong-performing quality Growth stocks and sectors. We are gradually adding some reopening stocks, given valuation extremes and recent news on the vaccine.
In terms of styles, we are more balanced between Growth/Value and are reducing the momentum bias as a source of funding, despite our longer-term positive view.