Hype abated, but the cycle is yet to run its course
When it comes to market sentiment, a quarter can make a world of difference. Much hype surrounded value during the first quarter of 2021. Now, throughout the second quarter, we’ve seen index leadership narrow and multiple dispersion once again approach dot-com bubble extremes.
But from the outset, we noted the market rotation into value earlier this year was led by the worst-performing sectors of 2020 – those sold down as COVID-19 shocked markets, as well as US equities (as the US led the developed world vaccine rollout).
So, despite the hype, we believe investors have only seen the first phase of an ongoing rotation in market leadership. This early stage is driven by normalising inflation rather than expectations around economic growth.
Towards investment-led growth
Despite the recent consolidation in cyclicals, we don’t think the cycle has run its course.
Initially, it can extend in response to the amount of fiscal stimulus we’ve seen and the strength of household balance sheets. The US household has never been in a stronger position to consume above trend.
Negative real yields are at odds with the health of the global economy, and a normalisation in real yields will fuel the rotation in equity preferences. Higher yields force investors to reassess the price they are prepared to pay for growth – they will act as a headwind for weak and overvalued growth stocks.
The rotation can then gather further momentum with new investment cycles.
Central banks don’t want to keep expanding their balance sheets at the same pace, and the pandemic itself has changed policy makers’ attitudes toward fiscal spending. There will be a reluctance to move to austerity too quickly.
Investment programs focussing on decarbonisation, infrastructure, 5G and catch-up investment in healthcare will continue to attract government attention. This, coupled with an unbundling of global supply chains thanks to COVID-exposed vulnerabilities and geopolitical tensions, can unleash a sustainable investment cycle - something that’s been missing from the West as capital spending moved to China over the past few decades.
New market leaders will emerge from this investment-led growth, and new investment cycles lead to a more permanent shift away from a perceived low growth, low rate environment.
Key risks for equity investors today
US equities have never been more expensive in the last 25 years, both in a relative and absolute sense. Overexposure to the US leaves investors vulnerable, particularly if the US job market doesn’t fully normalise by the time stimulus expires in September. Excess household savings could remain unspent and consumption could slow.
Critically, this would unfold against a backdrop of higher inflation – we don’t see US core inflation peaking until the end of next year.
The risk is the economy slows materially before the investment-led recovery gains traction.
A significant slowdown in activity against a backdrop of higher inflation is a nightmare scenario for US equities in particular, given elevated starting valuations.
Today, the rest of the world is valued at a 40% discount to US equities – and this discount is as extreme as it’s been in 25 years.
Given the US is home to big cap tech, secular trends around software and the internet have disproportionately benefited US equities. Whereas emerging investment cycles around decarbonisation and investment will benefit companies globally, not just in the US. This extraordinary premium for US equities is unlikely to be as sustainable as many believe.
Like many, we are also watching COVID-19 data intently. The Delta variant appears to be more transmissible but fortunately, the current data shows transmission is not translating into proportionately higher hospitalisations or fatalities in countries where vaccinations are well-progressed. The UK is an important test case to monitor, but at this stage, a return to widespread lockdowns in the northern hemisphere appears unlikely.
Business resilience will be rewarded
Investors should position for an ongoing rotation in market preferences and in an environment where inflation proves sticky, owning resilient businesses with embedded growth is key to this. Market leaders are in a better position to manage inflation through their cost base and pricing power.
The consolidation in cyclical stocks in recent months provides an opportunity to position for this rotation at attractive valuations.
Dutch banking giant ING Group is a great example and a beneficiary of ongoing European reopening.
It is a well-capitalised retail bank with more than half of its loan book in Northern Europe and around half in residential mortgages, where it is a dominant player. It isn’t under threat from savvy fintech, in fact, ING is arguably the original disrupter given its predominantly online business model.
As regulators lift restrictions on distributions (a precautionary measure taken by regulators globally in 2020) ING has scope to lift its payout ratio given considerable excess capital. This can act as an additional catalyst for re-rating. We see the company valued at 10x earnings with a sustainable 8.5% dividend yield.
We also own Oracle Corporation. It’s an incumbent software platform that looks cheap relative to its growth rate and cheap relative to smaller peers. Oracle’s revenue will accelerate as database workloads transition to the cloud, and as the company takes share in cloud ERP where it is the leader.
We are comfortable taking exposure to sensibly priced large cap internet and software businesses that are well-positioned for long-term structural trends like cloud, social commerce and digital advertising. We struggle to rationalise the valuations of their smaller, narrower competitors.
In this environment of very easy money, markets are not pricing credit risk and we’re not seeing the normal cleansing of weaker competitors.
Disruption is real. Not all low multiple stocks are interesting, there will be some that are permanently disrupted – we need to avoid the value traps.
But not all high-flyers are genuine disruptors, and growth traps will be revealed.
As a pragmatic value manager, it’s about having exposure to companies across the growth spectrum, that are attractively priced for their growth profile - simply speaking, avoiding value and growth traps.
Listen to Antipodes Partners' 2Q investment update on the Good Value podcast.
@ 0.40: Examining growth outperformance in 2Q and the rotation in market leadership
@ 5.45: How the market rotation can gather momentum
@ 9.55: Is the US premium sustainable?
@ 13:45: The key risks for equity investors today
@ 19:50: Portfolio positioning (stocks discussed: ING, Airbus, Microsoft, Facebook, Tencent, Oracle).
@ 24:50: Investing in China and the Asia region against a backdrop of regulatory and geopolitical concerns
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Jacob Mitchell is Antipodes’ chief investment officer. He is an award-winning fund manager, with more than 25 years' experience investing in equity markets. Jacob founded Antipodes in 2015 after deciding to leave Platinum Asset Management where he...