Yes, investors should consider making tactical changes because of valuation differentials exacerbated by the COVID-19 pandemic, but they should size them appropriately given elevated uncertainty. The course of the virus and potential for further stimulus remains unclear, other risks loom on the horizon, and depressed valuations reflect softening fundamentals in some cases. We favor small overweights to some of the assets largely left out of the recent rally, such as value stocks, small caps, and select non-US markets, as well as select opportunities in private credit. At the same time, we are cautious about reducing exposure to secular winners that benefit from trends the pandemic has accelerated while mindful that valuations, like trees, can’t grow to the sky.
Markets have been on a roller-coaster ride since cases of COVID-19 were first recognized in China in late January. As cases spread across the globe over the course of first quarter, risk assets plunged deep into bear market territory. Policymakers responded in force, unleashing record amounts of fiscal and monetary stimulus. The economy and earnings are rebounding but remain depressed. Valuations of some risk assets look stretched again, seemingly pricing in a full recovery.
Higher asset prices are justified in some instances by an acceleration of recent trends that is boosting earnings for dominant players in e-commerce and technologies that facilitate remote work (e.g., cloud computing, video conferencing). Historically low interest rates are also boosting the present value of anticipated future earnings, especially for relatively long-duration growth stocks. Still, in others performance seems to have decoupled from fundamentals. Growth stocks in developed markets have outperformed value equivalents by nearly 30 percentage points (ppts) year-to-date. The US gap is even wider and multiples for US growth stocks are now 3 times those of their value compatriots. Earnings for growth stocks are outpacing that of value peers, but sky-high valuations leave these companies vulnerable to changing assumptions around growth, interest rates, or political headwinds.
Similar dynamics are driving the outperformance of US equities overall, creating a related opportunity. US stocks have outperformed global peers by around 13 ppts year-to-date and approximately 60 ppts over the past five years. Investors should lean into non-US stocks, which now trade near a record discount to US equivalents. This is not a bet on the course of the virus or when economies will fully reopen, but a way to play the expected convergence of valuations between the two assets. Still, we’d highlight that China and some Asian economies have recently experienced greater economic growth than the United States, and earnings growth in emerging markets, in general, is expected to be stronger than that seen in the United States.
Investors should also boost allocations to small-cap stocks. Developed small caps have trailed large- cap peers by around 1,000 basis points year-to-date (though more in the United States). Some of this performance may be justified by sector and business model differences, with, for example, global technology and financial companies outperforming regional peers and in general having stronger balance sheets. Earnings for small caps have also taken a beating, with the consensus expecting roughly four times the drop expected for large caps in 2020. However, these stocks now trade at near-record discounts to large-cap equivalents in some markets, leaving room for their more cyclically exposed earnings to stage a fierce rebound as economic data recover in the quarters ahead. Investors making any of these valuation-driven tilts to portfolios should ensure they don’t result in an excessive underweight to technology stocks, which can be prevented by using active managers or offset in private equity sleeves.
Backstops from the US Federal Reserve and other central banks have also limited the opportunity set in many credit asset classes. However, spreads remain elevated for assets outside the purview of these programs, such as some types of structured credit. In addition, the opportunity set has grown for private credit strategies. Direct lenders are finding better terms and wider spreads as some participants pull back from the lending markets, and the downturn means credit opportunity funds are seeing rescue finance situations and motivated sellers.
Summing it up, investors should make small tactical shifts, but understand that much remains uncertain on the macro and virus front. The same conditions that have exacerbated valuation discounts of some assets could be present six or 12 months from now, so patience is required for these shifts to bear fruit.
Wade O’Brien, Investment Managing Director, Global Investment Research Team