European equities: Earnings growth still uneven across sectors
European equities ended February with Value sectors such as banks outperforming. The rotation in favour of Value and small caps continued as a result of the expected post-pandemic normalization, higher commodity prices and rising bond yields.
New COVID-19 cases are falling in Europe. However, hospital and ICU-bed occupancy rates remain pretty elevated. EC President Ursula von der Leyen admitted delays in the vaccine rollout. The goal now is to vaccinate 70% of the adult population by the summer. In the meantime, many countries are extending selective lockdowns.
More virulent coronavirus variants are spreading rapidly across the Eurozone, and restrictions on mobility are not expected to be lifted anytime soon. As expected, private consumption suffered in Q4 2020 and weighed on GDP growth.
Governments’ policy response has been determinant in cushioning households’ and firms’ income. Nevertheless, firms’ operating income has been severely impacted and loan demand for investment remains weak. Households’ savings intentions remain elevated, despite €500bn of excess savings having already been accumulated in 2020. Finally, the ECB will remain accommodative to preserve favourable financing conditions.
The vaccination pace is much slower than in the United States and the United Kingdom, but it should accelerate and allow GDP to return close to its former track by end-2021: on average, GDP should grow by 5.1% in 2021. However, the labour market situation is worrying households and weighing on their confidence, which remains significantly depressed
Negative earnings growth of -3% for the MSCI Europe (compared to its end-2019 level) is expected by the end of 2021. This projection seems to support our scenario of an almost-erased earnings loss by the end of 2021. However, earnings growth remains uneven across sectors. The Materials, IT and Utilities sectors seem to be the winners of this crisis, supported by both recovery plans and the acceleration of mega-trends such as digitization and the fight against climate change. Unsurprisingly, the Energy and Finance sectors seem to be more durably impacted, recording an earnings drop of -29% and -12% respectively compared to their end-2019 levels.
Valuations of Financials, Energy, Consumer Staples and Healthcare are attractive. Despite the ongoing economic normalization, rate increases and higher petrol prices, Financials and Energy remain attractive. Healthcare and Consumer Staples continue to underperform, as they have done over the past few months. Their defensive profiles do not seem to interest investors, given the ongoing reflation trade. However, valuations of these two segments are very attractive, given their future growth prospects, good Q1 results and low risk level.
In terms of sectors, Energy, Financials and Materials outperformed, as a result of higher commodity prices and rising bond yields. On the other hand, Information Technology underperformed, with some quite logical profit-taking occurring after their 2020 ride.
In terms of themes, Value was the best performer, while Growth and Momentum underperformed.
Since our last publication, our strong positive conviction on Financials and strong negative conviction on Utilities have paid off, as a result of the ongoing reflation trade and increasing competition in the renewable energy sector.
Value versus Growth rotations could continue in the coming months. The risk of a return of inflation that could materialise in mid-2021 is fuelling a trend of rising yields. Value versus Growth rotations, which could continue as we progress towards the end of the pandemic, are supported by rising commodity prices and rising yields, which particularly benefit Financials. However, in our view, this outperformance of the Value style is a short-term phenomenon. We are convinced that the Quality/Growth style – supported by sectors like Information Technology along with secular growth drivers – should outperform in the medium/long term.
As a result, we increased our grade on Consumer Staples, given its very attractive valuation and very low risk level. This sector is a high-quality and long-term outperforming player. In addition, during the last 4 months, it has lost more than the outperformance created for it by the COVID-19 crisis. Finally, the sector is highly underowned versus its benchmark and its history.
All other grades remain unchanged.
US equities: Rotation in favour of Value and small caps
US equity markets closed the month higher. The rotation in favour of Value and small caps continued as a result of the expected post-pandemic normalization and rising bond yields. Higher commodity prices have contributed to higher inflation expectations and many industrial metals also rose.
New COVID-19 cases are falling in the US, thanks to the ongoing mass vaccination campaign. President Biden got off to a quick start by signing a series of executive orders aimed at regaining control of the pandemic. Data on infections continued to trend down and the vaccine rollout accelerated. Vaccine producers are expected to provide 600 million doses, covering the adult US population, by 4 July.
The epidemic resurgence weighed on activity in Q4 but is now receding and momentum remains robust. Manufacturing surveys continue to show solid momentum, aided by extended fiscal support, which is boosting demand for goods. Consumption bounced back in January and February after a weak end-of-year but consumer confidence is still well below its pre-crisis level. Finally, the employment rate remains far from its pre-COVID level.
Extra stimulus is expected from the Biden administration. The American Rescue Plan that has been signed will provide substantial support to household disposable income, which should reacquaint consumption with its pre-crisis trend.
Inflation is bound to accelerate from depressed levels but wage inflation – due to lagging employment – is still a long way down the road. The expected approval of President Biden’s fiscal programme should boost the US recovery with positive spill-over effects. However, government spending is creating a concern around potential inflation. Core government bond yields are rising as markets price in higher future growth and inflation expectations. We revised GDP growth expectations for 2021 from 5.1% to 6.2% after a 3.5% contraction in 2020.
What is becoming more likely is an “above-trend” growth scenario that would meet Fed and Treasury policy objectives without necessarily triggering long-lasting inflationary pressures. Our scenario assumes a gradual end to social distancing, thanks to most of the population getting vaccinated by summer 2021. Upside risks could materialize if households spend some of their accumulated savings.
The earnings growth of the MSCI US is expected to be +13% at the end of 2021 compared to its end-2019 level. However, this growth remains uneven across sectors. On the one hand, growth within the IT and Materials sectors – supported by recovery plans and the ongoing digitization of society – is expected to be +29% and +26%. On the other hand, the Energy and Real Estate sectors seem to be durably impacted by the crisis, with earnings levels of -35% and -26% respectively compared to 2019. However, it is not to be excluded that earnings expectations for the energy sector will pick up due to the recent rise in oil prices. Finally, the Financial sector, which was heavily impacted by the crisis, should – helped by the sharp rise in interest rates and low provisions – return to its 2019 earnings level.
In terms of sectors, Energy, Financials and Materials outperformed as a result of the expected post-pandemic normalisation, higher commodity prices and rising bond yields. On the other hand, Information Technology and Consumer Discretionary underperformed, in line with the ongoing Value run.
In terms of styles, Value and Min Vol outperformed, while Quality/Growth underperformed, as some quite logical profit-taking occurred after their 2020 ride.
Since our last publication, our positive grades on Financials and Materials have paid off. However, our positive grade on the Healthcare and Technology sectors couldn’t stop us losing out, despite their good Q1 results.
As for the European markets, Value versus Growth rotations could continue in the coming months.
As a result, we downgraded the IT sector from +1 to neutral in a purely tactical move, as we remain for the medium and long terms very bullish, but rising 10Y interest rates convinced us to lower our rating in the short term. However, it’s a real Neutral far removed from “Sell”, as earnings were good and, again, industry drivers (innovation, IT infrastructure, 5G, semiconductors) are great.
We upgraded our grade on Consumer Staples from -1 to neutral, as the sector has underperformed on a 10Y move and valuations are too low to remain UW.
All other grades remain unchanged.
Emerging Markets: Inflation fears
Global equities started February where they left off in January, continuing their upward trend. For most of February, emerging markets continued their outperformance, before giving up the gains in the last week.
So, while global equities ended February higher, emerging markets underperformed. On a year-to-date basis, emerging markets still outperformed.. The source of the worry was inflation fears driven by the vaccination-driven expected global growth revival and rising price levels in commodities, energy and even semiconductors. These impacted longer-term interest rates, with the US 10Y Treasury yield rising by 34bps over the month, to close at 1.4%. While 1.4% over 10 years would not seem high from a historical perspective, it was the pace of this rise in yields and the drop in bond prices especially that spooked investors in other asset classes as well. In this environment of stronger growth expectations and rising yields, longer-duration asset classes like growth stocks – the most vulnerable and susceptible to correction – saw profit-taking, against a revival and outperformance of "value" and cyclical stocks in the last week of February.
On a regional basis, Asia ex Japan and EMEA both contributed a positively while Latin America corrected on the back of a negative performance from Brazil, driven by investor concerns over political risks and the replacement of the CEO of Petrobras. China was the main underperforming market, with the leading big tech and healthcare equities seeing a correction, with rising yields. The continued strong semiconductor demand helped the tech-heavy Taiwan market, whereas Indian markets cheered the Modi government's spending and growth-focused budget.
At industry-group level, as expected, value and cyclical sectors outperformed the higher-growth sectors. Real estate, materials and consumer services were the leading industry groups, whereas autos and healthcare lagged.
As a result, we increased our grade on Banks and Insurance from 0 to +1 as these sectors benefit from the ongoing Value rotation. In addition, we think the value run should continue over the coming months.
We decreased our grade on Consumer Discretionary, a sector under pressure from profit-taking and rotation to value. We also decreased our grade on Hardware & Equipment from +1 to 0. However it is a tactical move given the ongoing value rotation, as we still see positive short and long term dynamics.
We keep our neutral grade on Health Care Equipment despite the current market rotation. However in our views this sector remains a long term winner.
We tactically decreased our grade on China from +1 to neutral, as we see a rotational move out of China/growth/momentum, economy pre-COVD level, monetary policy less supportive (relative to US), PMI slowing.
We decreased our grade on Russia from +1 to neutral, “Value” market but market under pressure from ESG consideration and geo-politics (sanctions)
We continued to keep a balanced portfolio, combining value/cyclical and ‘opening-up’ exposure with quality growth stocks and sectors (technology, healthcare, CD) somewhat protecting the portfolio from profit-taking in more interest-rate-sensitive and longer-duration growth stocks, which came under selling pressure towards the end of the month. As a result, in terms of styles, we are more balanced between growth/value and are reducing the momentum bias as funding source, despite our longer term positive view.
