Time for a break

Stock markets have rebounded strongly since the end of March, when we argued that, down 30% from their peak, equities were already reflecting most of the earnings downgrades that should be expected in a recessionary environment. With the risk-reward of stocks now less attractive, in our opinion, diversification remains key.

Fundamentals remain clouded

As companies continue reporting first-quarter earnings, indications of 2020 earnings remain blurred.  While year-to-date profits expectations have been lowered by 16% in the US and 19% in Europe, the degree of confidence in these number is low. At the same time, 2021 earnings have seen limited revisions, leaving the “bottom-up” consensus expecting 2021 profits to recoup all the drawdown from 2020 and then grow some. Indeed, according to Refinitiv data as at 20 April, companies in the S&P 500 are forecast to generate earnings per share of $172 in 2021 versus $160 in 2019.

Similarly, in Europe, earnings are expected to grow by around 5% over the same time period. This more “V-shaped” recovery appears optimistic.

Pick your multiple

Even if we knew what earnings would look like this year and next, equity investors would need to decide which valuation multiple to apply in deciding the worth of companies. As a guideline, the following table shows the upside potential to the S&P500 (from 2,800) based on both earnings and valuations. In other words, at current levels, the US equity market is trading at around a multiple of 16.5 times earnings for the 6% growth expected.

Importantly, over the last 35 years, the index has traded at an average of 14.3 times the earnings expected in 18 months’ time. This number is the same if we look just at the last 10 years and exclude the “dot-com” bubble of two decades ago. In order to see further upside in the short term, fundamentally speaking investors should be willing to pay more than one standard deviation above the 10-year average, or should expect earnings to be more than 10% higher in 2021 compared with 2019.

Again, while financial markets can overshoot fundamentals in the short term, we are sceptical of such a scenario.

Science holds the key

While equities could move higher, there appears to be limited short-term catalysts for this to happen. Indeed, with a V-shaped economic recovery already priced in, we believe that the positive catalyst would have to come from science in the form of a vaccine to COVID-19.

While various drugs are showing promising results in early trials, a cure may not necessarily allow things to return to normal quickly. For one thing, social distancing measures (and the associated strain on some companies’ ability to operate) are likely to remain in place to avoid another wave of contamination.

To really put this pandemic behind us, a vaccine will be needed. Unfortunately, despite an unprecedented concerted effort globally, if successful, a vaccine is unlikely to widely available before the middle of 2021.

A lot could go wrong still

In the meantime, the risks are numerous. If severe, containment could be re-instated, harshly damaging any hope of a quick recovery. At the same time, the long-term effects of this crisis are still unknown. While this recession could be one of the shortest in history, it may be one of the worst.

With many companies scrambling for funding, banks setting aside billions in provisions for future defaults and millions of employees being furloughed, it is possible that the situation won’t normalise for months. As such, the economy in general, and consumption in particular, is unlikely to recover swiftly. Finally, political uncertainty could resurface with a US election still scheduled for November and Brexit set to become an economic reality by the end of the year.

A range bound view

While we do not expect equities to revisit March’s lows (unless a second wave of infections forces the developed world back into containment), we believe that the market is likely to take a breather in coming weeks and let fundamentals resync with current valuations. This is also justified by investors’ sentiment which seems much more “neutral” today, far from the doom and gloom of late March but still relatively cautious given the ongoing uncertainty. As such, we expect equities to remain volatile in a relatively wide trading range.

A time to diversify

With volatility elevated, diversifying multi-asset portfolios is key to protect and enhance returns. We continue to see merit in using less directional strategies to extract alpha, or outperformance, while being less correlated with other asset classes and to improve and to improve the overall risk/reward profile of portfolios.

Within equities, we maintain our preference for “quality” and cash-generative companies and sectors such as healthcare, and parts of consumer discretionary and industrials.

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