Is the global economy’s uneven recovery leading to more opportunities for equity managers? The answer: Yes, according to our latest quarterly report on equity managers.
Our newly released findings from the second quarter of 2021 indicate that the volatility surrounding the recent reversal in market sentiment is creating additional opportunities for skilled managers. We expect this to remain the case in the months ahead as concerns over inflation and the spread of the delta variant of Covid-19 are likely to make for a continued unequal—and somewhat bumpy—recovery. Ultimately, however, we believe that both the sentiment and fundamentals for a global economic recovery remain intact.
Overall, while most indexes posted strong absolute returns during the second quarter, there were key differences in the underlying drivers that impacted the performance of equity managers within various regions. The environment was more favourable for global ex-US, emerging markets, Europe, Japan and US small cap equity managers, while proving to be more challenging for US large cap, global, UK, Australia and Canada equity managers. More defensive managers also generally struggled during the quarter, given the strong up-market environment.
The momentum and growth factors were standout performers across most markets, with the low volatility and value factors lagging. Not surprisingly, this led to a cooldown in more cyclical sectors, such as industrials and materials, while technology surged in most regions. The one notable exception to this was in emerging markets, where the exact opposite occurred. The second quarter also saw strong performance in the energy sector, while the consumer staples and financials sectors lagged on a relative basis.
While some managers have selectively trimmed their value and/or cyclical exposures, this has been largely due to the strong performance in these areas since the fourth quarter of last year, rather than a change in conviction. Many managers continue to be positive on the commodity cycle as global growth recovers—in particular, in companies involved in the extraction/production of materials supportive in the move toward clean energy and electric vehicles, such as copper and silver.
Importantly, despite the rotation during the quarter toward growth and some of last year’s winners (particularly the FAANG (1) stocks in the US), market concentration continues to fall, with broadening market leadership—which we see as a positive for active management. In addition, cross-sectional volatility and valuation spreads remain attractive, which are also supportive for skilled equity managers.
Drawing on our unique relationship with underlying managers, we’ve compiled these and other insights from specialists across the manager universe into an easy-to-read report. Listed below are the chief tactical observations from key equity and geographic regions around the globe during the second quarter of 2021.
Outlook still positive, managers retaining cyclical positioning
• Despite the ASX 300 index rallying 13% year-to-date and the swing against cyclicals as bond yields fell in the second quarter, managers remain favourable on the outlook, with strong domestic employment (job vacancies up 23% in Q2 and 184% year-over-year) and the building boom being supportive.
• Companies which will benefit from a strong domestic and global economy remain in favour - i.e., energy, materials and industrials.
• Managers are factoring in how higher hurdle rates on new projects (due to environmental requirements) are constraining supply, providing an additional tailwind to energy and resources names.
• Managers have been adding to travel-exposed companies over the past quarter due to the positive impacts on the Australian economy.
Inflation hedging with insurance
• While managers believe that the increase in inflation is transitory, they have noted that if inflation is higher than expected, their insurance holdings will benefit.
• Fundamentally, managers are buying or adding to insurance companies as they consider that premiums are rising. Some have noted that they are buying insurers that they haven’t owned for over five years, due to industry tailwinds.
Economic recovery remains strong
• Managers are unequivocally positive on the sustainability of the current market and economic expansion. Optimism on vaccine trends and better-than-expected earnings growth are the key drivers giving managers conviction. However, managers are guarded about another spike in cases during the winter influenza season among the unvaccinated population.
• Bank stocks are favoured on future loan growth, mergers and acquisitions revenue and the expected easing of buyback and dividend restrictions during the second half of the year.
Inflation debate to continue
• Scenarios range from a major deluge of travel and entertainment spending (transitory) to more subdued scenarios. Most managers agree that early cycle inflation may fluctuate, while a longer-term sticky-price inflation of goods/services is more concerning.
• Managers cite opportunities in metals and mining stocks as having the most runway, given supply/demand imbalances as well, if inflation persists longer-term.
Growth managers finding opportunity in new economy stocks
• Recent initial purchase offerings (IPOs) of new economy technology stocks, along with non-traditional financials, are seen to be key to positioning.
• Growth and growth-at-a-reasonable-price (GARP) managers are looking through immediate earnings volatility in favour of longer-term sustainable trends.
GARP managers favour higher margins
• GARP managers see more opportunities in higher-margin companies and cyclicals, citing benefits from high levels of inflation and asset-price inflation within the economy.
Value managers see further rotation playing out
• Value managers continue to lean into the value rotation, trimming expensive names while adding to existing energy, financials and base materials holdings. New ideas are scarce, resulting in low turnover.
Emerging markets equities
It’s a stock-picker’s market in current recovery environment
• The resurgence of COVID-19 and delays in the reopening of certain markets continues to provide opportunities for the reopening trade. Some of these also benefit from potential strengthening in currencies, i.e., Brazil, Turkey, and South-East Asia.
• Commodities remain attractive, with longer-term support driven by the pick-up in global growth and supply tightness.
• Shipping companies are likely to continue to benefit from the normalisation of global trade as well as tightness in logistics and supply chains.
• Real estate remains attractive due to China’s policy-driven selloff, as it’s a latent beneficiary of retail and office reopenings.
• Amid the Covid resurgence, emerging-markets (EM) managers are slowly adding to specific travel-related opportunities, i.e., Macau and airports.
Balancing internet plays but dodging the regulatory bullet
• Growth managers remain bullish in certain China e-commerce plays, such as content providers and logistics businesses, while cautious on platform giants exposed to anti-monopoly and data-protection crackdowns.
Capturing the shift in global-EM dynamics
• The push for clean energy continues to drive positive sentiment toward cheaper valuation plays within the renewable energy and electric-vehicle (EV) supply chain. Managers are also supportive for certain commodities.
• Carbon emissions standards are driving consolidation in the steel industry, with a move toward cleaner, higher-quality steel production.
• Managers are topping up on Taiwanese and Korean tech hardware due to the continuation of semiconductor demand across consumer and industrial applications, as well as a tightening in the supply chain.
• Growth managers are building further exposure to China re-listing ideas, such as stock exchange and onshore financials, in order to exploit ongoing China-US tensions and Chinese IPO disruptions.
Europe and UK equities
Still a good runway for the post-Covid reopening
• Businesses hit hardest by the pandemic are still well-placed for a recovery, given pent-up demand and high levels of disposable income, i.e., opportunities in hotels, airlines and gym groups.
• Medical equipment manufacturing remains an attractive area.
• The pull-back at the end of the second quarter on some reopening plays, as lockdown uncertainties re-emerged, provides entry opportunities.
Is it time for the services sector to play catch-up?
• Europe has relatively high exposure to cyclical sectors, such as industrials, which have benefited from the start of a more positive economic cycle. As economic activity normalises, there is an opportunity for the services sector to play catch-up to manufacturing-related firms that have had greater participation in the recovery so far.
UK construction opportunity
• The outlook for construction in the UK and abroad remains strong, both in terms of housing and infrastructure, thereby presenting opportunities in this sector.
Reappraising the valuation gap between the pure EV players and traditional car manufacturers
• Investors have been paying considerably for anticipated future growth of new world car makers. Meanwhile, old world companies like Volkswagen have, until recently, been valued as though they were distressed businesses.
• As the traditional car makers continue to ramp up their EV offerings and research and development efforts, investors are increasingly reappraising the valuation gap relative to pure EV manufacturers.
Global managers investing in the UK
• Global fund managers reported overweighting the UK for the first time since 2014, as sentiment improves while valuations remain attractive versus other regions. The business cycle is also supportive.
Global and international equities.
Minimal reaction to inflation risks
• Managers across investment styles remain largely unperturbed by inflation risk, believing it to be transitory. Despite some supply-chain bottlenecks and increased money supply, consistent price pressures are absent. Few have made rotations to hedge against inflation outside of pre-existing positions.
Commodity sentiments are coloured by ESG considerations
• Commodities with positive links to environmental, social and governance (ESG) trends, such as copper and aluminium, are gaining interest.
• Some managers are avoiding oil, given worldwide decarbonisation efforts, although deep-value investors continue to see vestigial opportunities in the next few decades.
• Semiconductors and memory may be the new commodities. The growing EV market demands more chips per vehicle, and the broader internet of things trend shows no sign of slowing.
Banks confront headwinds
• US banks face a glut of cash deposits with no offsetting demand for loans. The surfeit in money supply may dampen any potential benefit from a rate increase.
Managers shy away from regulatory risk in China, look toward EMEA
• Managers are reducing their China exposures on regulatory uncertainty, given intensifying scrutiny of domestic tech giants.
• They are finding more attractive opportunities in EMEA, which is benefiting from the reopening trade. A second wave of Covid-19 delayed the recovery in Europe, but economies have begun to rebound.
• However, China bulls point to a history of Chinese industries successfully adapting to similar regulatory pressures, and long-term ESG opportunities in materials and commodities.
Delta variant resets the stage for reopening trades
• Managers who trimmed recovered cyclicals and added to defensives are now eyeing cheap reopening plays again as the delta variant throws markets back into lockdown and uncertainty.
Earnings revisions peaking
• Managers gradually trimmed well-performing cyclical stocks during the second quarter, believing that the current economic recovery, driven by a favourable inventory cycle, had largely been reflected in stock prices.
• Analysts’ earnings revisions have been peaking, despite still being in positive territory.
• Further demand recovery from a normalisation of global economic activity in the second half of the year could lead to additional upward revisions.
Changes in inflation forecasts are still key for stock selection
• Managers are paying close attention to inflationary pressures. Their views are mixed, with many believing the rise in inflation will be short-lived, given that it’s driven by temporary supply shortages. Others, however, expect it to be structural, as supply chain-restructuring or ESG-friendly policies will likely drive more persistent inflationary pressures.
• Those who expect inflation to not be transient have been adding to their financial exposure as a hedge.
Reopening theme continues
• The slower vaccination rollout in Japan offers opportunities for beneficiaries of the reopening trade. Japan’s full vaccination ratio remains low, standing just above 20% as of mid-July.
• Many managers continue to make tactical shifts to domestic demand-driven businesses, i.e., retail and transportation, rather than exporters.
Mixed views on China risk
• Many managers believe long-term geopolitical and regulatory risks with China will remain, which poses a threat to exporters.
• On the other hand, China’s aggressive investment in the tech sector has led to strong demand for Japanese technology.
Real assets equities
Pandemic accelerated secular real estate trends
• E-commerce: logistics and select retail
• Digitisation: data centres and mobile towers
• Sunbelt population drift: due to working-from-home shift
• Research and development: life science/lab space
Managers see fundamentals improving in second half of 2021
• Global real-estate cash flow and dividend growth are expected to rebound into positive territory, although underlying trends by the property sector are likely to remain highly uneven.
• Operating fundamentals are likely to improve as demand broadens, driving increased earnings visibility.
Office, retail and lodging recoveries will vary by quality, market, mix and duration
• Covid-19 vaccinations are driving a gradual return to the office. Uncertainty around office space needs and post-Covid layouts will likely lead to shorter lease terms and more capital expenditures.
• Grocery and needs-based retail aren’t materially impacted by e-commerce disruption.
• Unclear future for business travel.
Flurry of M&A activity anticipated
• This is due to the combination of an attractive cost of capital, rising replacement cost, lack of direct market opportunities and increased geographic/portfolio diversification efforts.
Managers see infrastructure opportunities in transport sectors
• Toll-road volumes have been less impacted by the shift to a work-from-home environment, which has affected public transportation more significantly.
• Freight traffic among North American railroads has proven resilient.
• Air travel is returning as restrictions ease, benefitting airports served by domestic flights.
US large cap equities
Reopening from Covid-19
• Many managers expect the reopening trade to continue as the country emerges from the Covid-19 pandemic, but believe that economic acceleration may be muted by vaccine reluctance and new virus variants. To mitigate this risk, managers are focusing on the competitive leaders and share gainers in pandemic-challenged segments of the stock market, versus buying several similar stocks that may benefit from the recovery theme.
• While many growth stocks benefited during the pandemic, including e-commerce and subscription-based models, these stocks will be facing difficult earnings comparisons in the second half of 2021. Managers believe that the ability to differentiate between the sustainable winners and the temporary winners will benefit active management.
• Managers are beginning to see a decline in the rate of inflation, but they expect inflation to be transitory for longer. Supply chains in multiple industries continue to experience disruptions and are also enduring increasing labour-cost pressures.
• Continuing inflation should benefit companies with higher profit margins and pricing power.
Bond-proxies vs financials
• While the US 10-year Treasury bond rallied and yields declined during the second quarter, it did not benefit the high dividend bond-proxy stocks in consumer staples and utilities. Managers see this as an indication that lower yield spreads are likely to be temporary in nature and not a signal of declining economic growth going forward.
• While bank stocks are challenged by low rates, managers are optimistic about the opportunity due to very attractive valuations, conservative balance sheets and the potential for loan growth and net-interest-margins to improve going forward.
US small cap equities
Managers remain optimistic on earnings, but growing cautious on small cap valuations
• As the economy continues to recover from the pandemic, managers are expecting a good earnings environment in the second half of 2021.
• Despite the favourable outlook on earnings, managers are becoming cautious on small cap valuations following five quarters of outperformance. In particular, they’re expressing more caution on cyclical sectors such as industrials, while remaining more sanguine on financials.
• Valuation-sensitive managers are now wary of multiple contraction, driven by inflationary pressures, as well as the potential for rising interest rates.
Managers’ growth vs value outlook in small caps
• While the Russell 2000® Value Index (R2V) remains more attractive than the Russell 2000® Growth Index (R2G) at any time since 2002 on a forward price-to-earnings (P/E) basis, managers are beginning to question whether the value rally can last as the R2V ended the quarter in a relative downtrend after only marginally outperforming the R2G.
High-quality small caps due for a rebound
• High-quality small caps have significantly underperformed recently, with relative returns from the past year still remaining several standard deviations below the mean. Managers believe this is normally the time when high-quality resumes leadership.
Small cap managers finding opportunities in financials
• Managers across the style spectrum are finding opportunities in regional banks, driven by a rising interest-rate outlook. Managers have also been rotating from some banks that have done well to those that have lagged so far.
The bottom line
The unevenness of the economic recovery is likely to continue through the second half of the year, with efforts to return to a more normal state of affairs dependent on the success of multiple vaccine rollouts. The potential impacts of the delta variant remain a key watchpoint for equity managers, as do the risks of persistently higher-than-expected inflation, which could cause central banks to tighten monetary policy sooner than expected, curbing growth expectations. Regulatory challenges and geopolitical tensions in China are also continuing to play a role in how managers are assessing risk.
Ultimately, we believe that the myriad of uncertainty around these issues will continue to lead to volatility and opportunity—and that the views of specialist managers will be crucial to exploiting both. We look forward to sharing these insights with you as the world continues to heal from the pandemic.
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