investment viewpoints

A crisis like no other - where to now?

September 9, 2020

Pascal Menges

CLIC Equities, CIO Office

Key Points:

Equity markets have moved from a near-term focus to a forward-looking one, assuming that a resolution to the pandemic crisis is not a matter of if, but rather when
Equity markets have therefore gone through a massive re-rating on near-term multiple +37% - typical for a crisis - look-through exercise, and we believe there is still some potential for expansion
Forward Equity risk premiums are at least as attractive today as they were between 2014 and 2018 (6% in the US, 8% in Europe)

GDP growth is not necessarily correlated with global equity market performance, but big economic slowdowns or crises tend to leave a visible print for investors. So far, this is not proving to be the case in 2020 (chart 1). After a major drawdown of almost 35% in March, the market’s rebound was rapid and such that the global equity index is now up, year-to-date, despite the major economic blow caused by the pandemic. This leaves us with a very simple question: where to now?

Chart 1: Global GDP Growth and Global Equity Market Index

A breakdown of year-to-date performance between earnings, dividends and valuations (chart 2) illustrates ongoing market dynamics. On average, earnings per share have been revised downward by ca 20%, ranging from UK equities being the worst hit, to US equities being the most resilient. Everything else being equal, such downward revisions should have driven equity prices lower to the same extent. However, a massive valuation expansion has occurred with global equities being now almost 37% more expensive than they were at the beginning of the year.

Chart 2: Key indices total return decomposition

Over the last 25 years, we can see two types of valuation expansion: one is due to a market bubble (’98-99), the other is down to look-through behavior during market crisis (chart 3). Indeed, even if near-term earnings are depressed, at some point market participants tend to look through a crisis as soon as they are comfortable that earnings’ forecasts are reliable enough to be used for valuation purposes. Typically, this level of confidence is due to macroeconomic developments such as interest rate cuts, accommodative monetary measures, fiscal easing etc. This shift in focus from near-term to forward earnings creates near-term PER expansion. The usual catalyst for such a shift in focus is when forward earnings start to stabilize and go through positive revisions, which serves as a catalyst for equity markets, even if shorter-term earnings continue to be revised downwards. This was the case in May 2020, just as it was in March 2009 or mid-2002.

Current 2020 PER for the market is close to 30x, compared to a peak of 37.5x in mid-2002 and 36.6x in December 2009. For some market participants, it seems atrociously expensive. However, these near term valuation multiples are now being put in perspective with forward earning growth of +29%, +28% at the end of 2009 and +26% in mid-2002. On that basis, a PEG ratio of close to 1 is even “attractive” when compared to the 1.3-1.4 range of 2002 or 2009.

Chart 3: Multiple expansion and crisis

The implied market view is that the unlocking of the economy from its pandemic linked-constraints is not a matter of if but rather when, and that the final tab is going to be put on the shoulders of central banks and governments with ‘minimal’ disruption to the listed corporate world. Therefore, we believe it is fair to use forward earnings to analyse global equity risk premiums, which capture both the valuation of the market and risk free rates adjusted for inflation. In our view, this analysis reveals three key points:

Equities are at least as attractive today as they were between 2014 and 2018
In absolute terms, European equity risk premiums remain more attractive than the US
Relative to pre-pandemic, US equities are marginally more attractive thanks to the collapse in risk free rate which has not happened to the same extent in Europe. Indeed, US 10y bond yields dropped from 1.9% in late 2019 to 0.7% by the end of August 2020

Chart 4: Global Equity risk premiums

The equity market is comforted by the fact that the world economy continues to recover rapidly from the pandemic. Global GDP seems to have now made up over half of the 17% drop that occurred between mid-January to mid-April. For instance, China returned to growth in the second quarter, with the expectation of a 6.9% annualized GDP growth in the second half of 2020, aided by significant fiscal support. High-frequency activity indicators in Europe have continued to recover, albeit at a slower pace. Following a second successive double-digit increase in industrial production, European activity is left about 10% below its pre-crisis level. The rebound story is similar in the US and, interestingly, the housing market appears strong, with new home sales accelerating markedly. Towards the end of the month, the Federal Reserve also explicitly introduced a higher tolerance to inflation and announced it will seek maximum employment. Combined with expectation of a COVID vaccine in 2021, which would help to unlock global activity, the sentiment is rather risk-on. Even the rise of a second wave of the pandemic across several countries, including a number in Europe, has failed to dampen market enthusiasm to look-through the near-term earnings wobble. Indeed, this second wave is so far very much concentrated in the younger part of the population with limited pressure put on hospitals and on death tolls. As consequence, containment restrictions being re-imposed have been lighter than during the first wave, with governments being very wary of re-imposing any nationwide lockdown that would impair the recovery.

The key risk for investors is that the pandemic situation changes drastically, dampening confidence. Or, additionally, that activity levels never fully recover from the economic scars left by the pandemic. This is not our base case scenario at this stage.

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