Reality check

06 March 2020

6 minute read

By Julien Lafargue, CFA, London UK, Head of Equity Strategy

The spreading coronavirus outbreak has hit stretched equity valuations, after many markets hit new highs earlier in the year. With more volatility on the cards, where next for equities?

Equities have had a turbulent start to the year. After the impact of the coronavirus epidemic on growth expectations, US attack on Iran and start of the US election race, much has happened since we published Outlook 2020 in November. As such, it makes sense to take stock and reflect on the path forward.

Our message to clients in November’s Outlook 2020 was that this would be a year of uncertainty and more modest returns across most asset classes. From an equity perspective, consensus earnings expectations looked too optimistic, even in a scenario where a “phase one” trade truce was soon signed.  On valuations, we felt that multiples had limited room to expand given their already elevated level and the myriad risks remaining on the horizon.

Earnings revisions still negative

Recent developments reinforce our view that consensus earnings expectations appear too rosy. Depending on the index, 2020 earnings estimates are already 2-3% below their level in November (see graph below). The coronavirus outbreak, a mixed earnings season and lower oil prices all point to further downward pressure on consensus estimates. As such, we still believe that global earnings will, at best, grow by mid-single digits this year.

2020 earnings estimates

20x earnings in 2020, really?

The surprise at the beginning of the year came from stock valuations which continued to expand despite earnings expectations being cut. In the US, the forward price-to-earnings multiple for the S&P 500 index has flirted with 20-times (20x) earnings, something seen only during the dot-com bubble of two decades ago. Before the recent sell-off, global equities were 10% more expensive than their 20-year average valuation.

We were puzzled: multiples typically don’t expand this late in an economic cycle, especially when growth is unlikely to re-accelerate. Bulls would point to the low interest rate environment and central banks’ support: There Is No Alternative (“TINA”) to equities nowadays. We agree that, on a relative basis, stocks remain the most attractive asset class but, on fundamentals alone, we could not justify prevailing valuations. Valuations seem more reasonable though, after the recent sell-off.

On a relative basis, stocks remain the most attractive asset class but, on fundamentals alone, we can’t justify higher valuations

Anatomy of a rally

Interestingly, the rally early this year felt forced. First, at a sector level, it was clear that investors are not banking on a sharp macroeconomic acceleration. In fact, defensive industries, those expected to perform better in a challenging environment, like utilities and healthcare, were leading the way. Meanwhile cyclical sectors, such as energy, materials or financials, have struggled to post positive returns recently.

Similarly, despite repeated calls for “value” to finally rebound and outperform “growth” assets, the higher quality sectors and stocks have continued to produce the best returns. We see no justification to alter our long-established bias toward quality, given the current backdrop.

Looking outside equity markets, most other asset classes send a cautious message: the US 10-year government bond yield has reached new historical lows while gold has touched a 7-year high.

Bond yields and equities

The rally before the coronavirus wasn't reflective of the kind of euphoria seen in the late 1990s, in our opinion. Instead, it was more the result of central banks’ action which, by pumping unprecedented amount of liquidity in the system, have pushed inflation away from the real economy and into financial markets. This environment may not be sustainable over the long term but, for the time being and as long as liquidity is plentiful, valuations should remain above their long-term average.

Adjusting our fair value estimate

At a price-to-earnings multiple of 18x earnings, corresponding to a one standard deviation from the historical mean, and based on mid-single digit earnings growth this year, we estimate the US S&P 500 index’s fair value to be 3,300-3,400. This is 100 points or so higher than we penciled in last November.

The above change reflects an even lower interest rate environment, with the yield on the US 10-year government bond having dropped close to 80 basis points (bp) in the past four months and the US Federal Reserve announcing a 50bp cut in interest rates to ease financial conditions following the coronavirus outbreak.

Despite this revision, equity markets’ upside remains somewhat limited in our opinion. As such, we continue to focus on risk-adjusted returns and alpha generation.

An even stronger case for active management

When first initiated by various central banks across the world, quantitative easing was seen as the tide that would lift all boats. Eleven years into this bull market and the tide seems to have started to come in, with investors questioning the marginal impact of further stimulus. This change in perception has resulted in significant performance dispersion for equities at the regional, sector and stock level. We expect this trend to persist, creating a much more supportive environment for active managers.

Diversification remains key

In a highly uncertain world, we believe that diversification remains paramount to achieve long-term objectives. The first few months of 2020 have reinforced that some historical cross-asset classes relationships may not hold true anymore with, for example, both equities and gold reaching new or long-term highs respectively.

Historical cross-asset classes relationships may not hold true anymore

From a portfolio perspective, we continue to like assets which offer diversification away from the traditional “60/40” equities and bonds portfolio. This includes commodities, of course, but also real and private assets as well as volatility, which we expect to remain elevated this year.


Market Perspectives March 2020

Financial market sell-offs, on concerns over the impact on growth of the spreading coronavirus, dented a strong start to the year and highlighted the attraction of diversified portfolios.


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