Outlook 2021: Global and thematic equities

Global equities are by no means cheap, but they are reasonably valued. Considering the scale of the pandemic they performed surprisingly strongly in 2020, and we think they will continue to do well in 2021. However, we expect the market recovery to broaden out across a broader range of sectors compared to the past 12 months.

Technology stocks - no sign of a bubble

The market rally in 2020 was led by a fairly narrow range of tech stocks. This was primarily due to the justifiable perception that these companies are dominant in their respective fields, have high rates of long-term revenue and earnings growth, and have been beneficiaries of forced changes to work, social and shopping practices during lockdown. In effect these companies were the “lockdown leaders”.

The mega-cap technology platforms now account for a quarter of the entire S&P 500 market capitalisation. Inevitably, this degree of concentration has drawn comparisons with the 1999 “internet bubble”. However, we believe this view is misplaced.

Covid-19 has clearly accelerated the adoption of new technologies such as e-commerce and remote working. These changes in corporate and consumer behaviour will likely continue after the pandemic.

In short, the “technological transformation” already underway well before the pandemic has simply been accelerated by Covid-19. Technology will continue to provide a fertile hunting ground for investors in the coming years. The biggest risk to the sector is likely to come from regulation, rather than any rapid diminishment in the underlying growth rate.

Market recovery set to broaden out

During 2020, investors flocked to safety amid the global uncertainty, with growth and defensiveness being a key part of the equation (as with the technology names). However, the announcements during November that several effective Covid-19 vaccines have been developed gave investors an incentive to think about “normalisation” and economic recovery in 2021 and 2022.

Investors have begun to look at the potential for revenue and earnings growth in many “out-of-favour” areas that suffered during the pandemic. The most obvious of these are those that were effectively shut-down, such as hotels, restaurants, leisure enterprises and travel companies. It seems highly plausible that when the recovery, takes hold many of these businesses will experience a sharp rebound.

In addition, expectations in cyclical sectors such as energy, materials or industrials are low and merit attention. It is clear that there are major structural challenges (such as the energy transition) that will continue to significantly affect many companies in these sectors in the future.

However, we believe that some companies will continue to adapt and prosper, and that a sustained pick-up in global demand in 2021 will drive significant revenue and profit growth. This will certainly be the case in many parts of the industrial sector in our view, as operating leverage (the sensitivity of profitability to a sales improvement, with a given level of fixed cost) will be substantial in many cases around the world.

We expect to see a significant broadening of the market in 2021. Technology can still do well, but some of the un-loved areas may do better still. We don’t see it being as simple as buying the cheap sectors and selling the expensive ones since, to quote the great Sage of Omaha, “Price is what you pay, Value is what you get”.

Not all cheap oil, commodity or industrial companies offer good value, and neither do all banks or insurance companies. There will likely be substantial dispersion in every sector as the global economy transitions in 2021. As such, stock selection remains highly relevant.

Valuations of global equities remain (relatively) attractive, especially outside the US

Global equities are, in aggregate, reasonably valued and in line with their long-term averages on a forward basis. The global dividend yield also remains materially above the bond yield, supporting the relative case for equities over Treasuries.

As an asset class, we believe they will continue to do well in 2021 as the recovery broadens out. It is worth noting though that after a period of massive outperformance by the US versus the rest of the world (around 8% annualised over the last 10 years), the US is now trading at a premium to its long-term normalised earnings valuation. Meanwhile, the rest of the world is now trading at a substantial discount.

European and Japanese profits are expected to rebound the most in 2021 and possibly in 2022 as well. The Chinese economy is already recovering, driving a powerful recovery dynamic across Asia as a whole. The US will remain a highly quality defensive equity market with by far the greatest depth and liquidity of any global market. However, while the flight to safety has created a flow toward the US, as the recovery takes hold, we believe this may partly reverse, and capital will begin to flow elsewhere.

Thematic investing will be even more relevant post-Covid

Most of us would agree that there are a small number of undeniable and substantial trends that have the potential to materially affect the way we live, work, socialise and interact in the future. Some of these “mega-trends” are not new: climate change, healthcare innovation, urbanisation, automation and digitalisation have been relevant themes for many years now. Others, such as sustainability, food & water provision and changing lifestyles are emerging as important and urgent areas of change, driven by population growth and rising consumerism in emerging markets.

The common denominators across all the megatrends are two-fold. Firstly, they are all becoming rapidly more relevant as humanity consumes a greater and greater proportion of the Earth’s resources. Secondly, the challenge of these trends is being met by rapidly accelerating innovation that is driving a technological transformation across virtually every sector and industry group.

It is this innovation dynamic that we believe creates a strong rationale for a themes-based investment approach. If we are right about the themes, and consistent in our approach toward assessing them, then in all likelihood having exposure to at least one of them could be highly incremental to a more traditional index-based equity portfolio. Given that many of the themes encompass different sectors and industries, there is also a high probability that allocating to them can enhance the overall risk/return profile of a portfolio over time.

Looking towards the new green industrial revolution

As an example of the rapidly increasing importance of certain key themes, global climate change is a case in point. In order to stabilise global temperatures within the +2 degrees C limit defined as “safe” by the Intergovernmental Panel on Climate Change (IPCC), spending on greenhouse gas mitigation will have to rise to at least $2 trillion a year over the next 10 years. That cost will have to be borne by governments, consumers and of course, companies.

The opportunity for growth is vast and still under-appreciated in our view. Momentum behind the transition to a low carbon economy is accelerating rapidly now. The most crucial driver has been the dramatic improvement in the competitiveness of clean energy technologies, to the point where they require little or no subsidy to compete with fossil fuels. Investments to displace combustion engine vehicles and fossil fuel power generation are now ramping rapidly, and we expect the next five years to be a critical inflection point in that transition.

We continue to believe the automotive sector is set for very rapid and fundamental change, with an accelerated adoption of electric vehicles (EV), taking EV penetration up towards 50% of global new car sales in 10 years’ time, and eventually close to 100%.

More broadly, the transition to a green economy will offer tremendous opportunities for investors as investment builds and adoption rates surprise on the upside. The same is true for other key trends where innovation is rising.

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