By Robert Ducker
Equities have made quite a start in 2021, with global equities up 3.7% on a year-to-date basis, as measured by the MSCI World Index in Euro terms. This is quite remarkable when considering the uncertainties that lie ahead but is also a reflection of the fading risks that have weighed on equities for some time. To put everything into perspective, global equities have rallied 73.3% since March 2020, which is almost identical to the rally post the financial crisis in 2009 (+79.7% over the same period). The strength and speed of this rally has led to some nervousness amongst investors, with this concern not unfounded when consideration is given to the rising COVID-19 cases and weak economic data.
There are increasing signs of complacency in the equity market with investors reacting to positive news but ignoring the negative news around rising COVID-19 cases (and the implication this has on curtailment measures) and economic data that comes in weaker than previously expected. Equities rallied by more than 20% since the announcement by Pfizer at the start of November that an effective vaccine has been developed. However, challenges remain and there are increasing signs that the market has gone ahead of itself. The current base case is for the global economy to recover sharply in the second half of this year. This view is based on a successful COVID-19 vaccine rollout, which should lead to the easing of curtailment measures that are currently restricting economic activity. There is currently no indication that this is unattainable but at the same time the risk that the recovery is delayed still exists and this is not currently being reflected in the equity market sentiment. Goldman Sachs’s risk appetite indicator has recently moved above 1.0 (high bullish sentiment), which is typically associated with a higher risk of correction.
On balance, we currently see a higher risk of correction in the near-term, as reality and expectations align. Looking back at the financial crisis of 2009, the rally that started in March 2009 was followed by a correction of circa -16% which started in April 2010 and lasted for a month. Therefore, it would not be surprising to see a correction during the current bull market that started in March. Investors may prefer to sit on the side-lines and wait to see some meaningful progress on the vaccine roll-out or wait for growth in COVID-19 cases to slow down. Others might have the view that a lot of good news has already been priced in.
Despite the risk of a correction in the near-term, we think that the probability of a bear market or a major drawdown remains highly unlikely. There are currently no indicators of stress apart from the high valuation levels, which are generally supported by the low interest rate environment. We remain positive on the prospects for value stocks during 2021 as for the first time in a very long time, we could be entering a period of strong synchronized global economic and profit growth. The measures taken by governments and central banks will help (loose fiscal and monetary policy) but the expected pick-up in personal consumption should be a significant contributor to economic growth, especially when looking at the high consumer savings ratio. This should be supportive for sectors with a high economic beta.
The valuation gap between growth and value stocks is currently at extreme levels, following the outperformance (in growth) seen over the past 12 years. It is important to caution that extreme valuations are rarely a trigger for a major rotation. Global growth stocks are currently trading at a 91.7% premium to value, compared to a 10-year median of 26.6%. The valuation premium has been expanding at a faster pace since 2018 (US/China trade spat) as investors paid a premium for stocks that could grow notwithstanding the headwinds for global trade. The valuation gap continued to widen during 2020 due to the outperformance of the “stay-at-home” stocks (mostly growth stocks). Although we do not expect the valuation gap to fall to median levels, it is reasonable to expect that the conditions in the near term will result in a lower valuation premium than is currently the case.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.