Putting E back in PE

Global equity markets entered 2021 with lofty valuations, following big multiple expansions since the COVID-induced market lows of March 2020. As the new year gains momentum, it is comforting to see continued positive earnings revision momentum broadening across regions and sectors, as would be expected in a post-recession global economy.

Below we compare the current market return drivers to historic equity market cycles, explore earnings trends seen in the recent reporting season and flag the risks ahead for equity investors as bond yields start to price in higher economic growth and potential inflation.

Investors need to understand the risks they are exposed to by investing in highly-valued companies, unsupported by a strong earnings outlook. It is during these periods of increased market volatility and significant style switches or regime changes, like the present, that a rigorous and tested investment process becomes even more important.

Alphinity’s style agnostic process, premised on earnings leadership, has allowed us to opportunistically tilt our Australian and global portfolios to the more cyclical part of the market by following the earnings leadership change over the last six months and continuously adjust our exposure to benefit from changing market and macro trends. 

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DRIVERS OF EQUITY MARKET RETURNS CHANGES DURING MARKET CYCLES 

Equity market returns are normally driven by a combination of earnings growth, rating changes (multiples moving up/down), dividend growth and FX adjustments. The contribution of each varies, depending on the economic and market cycles we are in.

Research by Goldman Sachs on historic equity cycles, suggests that nearly every equity market cycle can be split into four distinct phases: hope, growth, optimism, and despair. The extraordinary returns of 2019 were consistent with the classic ‘optimism’ phase that tend to play at the end of a prolonged bull market, with most of the gains coming from rising valuations. The ‘hope’ phase, which is the first part of a new cycle and usually begins in a recession as investors start to anticipate a recovery, is predominantly driven by multiple expansion, and can often be the strongest part of the cycle. 

The dramatic re-rating across global equity indices (20 to 90%) witnessed since the March 2020 lows to the end of last year were in line with the ‘hope’ phase of an equity market cycle, as markets are forward looking and already pricing in high expectations of an earnings recovery, even as earnings are still being adjusted downwards for current periods in many cases. The scale and speed of the recovery this time was however unprecedented. Then again, nothing about 2020 was normal!

Since the start of the new year, we have already witnessed a derating (5% to 30%) across global equity indices where earnings become the predominant driver, which is typical of the ‘growth’ phase. While each cycle is unique this phase often produces lower returns relative to other cycles (and higher bond yields can start to impact valuations). As Chart 1 reflects, the current move from the ‘hope’ to the ‘growth’ phase reflects historic patterns last seen after the Global Financial Crisis (GFC) during 2009/2010 and the 1999 Tech Bubble.

EARNINGS RECOVERY BROADENING OUT 

With end 2020 result releases now behind us, we can reflect on one of the best reporting seasons over the last decade. Not just abroad, but also here in Australia. Corporate earnings have generally beaten expectations by a bigger margin relative to historic outcomes and have led to persistent positive earnings revisions across all the major regions. Cyclical sectors, such as financials, metals and mining and consumer discretionary have seen broad-based beats and are leading earnings revisions.

Banks have been a standout sector globally, with more than 80% of banks reporting in the US, Europe and Australia beating earnings and dividend expectations. Resources companies have been benefiting from a perfect storm of higher commodity prices (positive demand/supply dynamics) and a weaker US dollar, but their strong capital discipline shown during 2020 is commendable.

‘COVID beneficiaries’, such as consumer staples and home builders, have generally been reporting even stronger than expected, whilst ‘COVID recovery’ sectors had to rely on cost cuts and government support to survive, although in economies like Australia some are already reporting improved conditions or outlook.

The pace of revisions is however peaking across most markets, except for Japan, global emerging markets, and Asia Pacific. The market reaction to positive surprises has also been a bit more muted than we’ve seen historically, implying that much of the good news to date has already been priced in by global equity markets through the ‘hope’ phase.

The focus from here should remain on earnings growth guidance to 2021 and beyond, which has largely come through either in line or ahead of expectations.

The breadth of earnings downgrades during 2020, were in line with that seen during the GFC (2009). On the positive side, earnings revisions have again turned positive and broadened, not just for the next financial year (FY1), but also for the year thereafter (FY2).

HIGHER BOND YIELDS ARE FLAGGING THE RISK OF UNPROFITABLE HIGHLY VALUED EQUITIES 

Equity valuations (PEs) are also influenced by other macro drivers, such as the change in bond yields. Bond yields influence the discount rate used in valuation models to determine the present value of a company’s future cashflows. Thus, the higher the discount rate, the lower the current value of future cash earnings (all else being equal) and therefor the current share price. The higher the valuation of a company, the longer the duration risk, as a bigger part of the company earnings are expected to come through over a longer period. So highly-rated companies (or long duration assets) have a higher risk of contraction when yields rise.  

In addition, certain sectors are more sensitive to a rise in bond yields than others. For example, global financials should benefit from a rise in bond yields (or interest rates) as they can charge more to lend out. More economically-sensitive sectors, such as small businesses and typical value companies will also benefit as higher bond yields normally imply that economic growth is starting to come through. On the other hand, defensive sectors such as telecoms, utilities and real estate investment trusts (REITs) normally suffer in a higher yield environment, as more cyclical companies become attractive (more growth opportunities), and the yield of income-producing companies becomes relatively less attractive vs investing in bonds.

Since the GFC, bond yields have been persistently trending lower (really since the 90s), underpinning equity valuations. This was particularly prevalent during 2020 when US rates fell below 1% and even before that with many other developed market yields falling into negative territory. Add massive levels of government stimulus and retail speculation to that cocktail and you see an explosion of valuations across certain sectors, such as technology, as we did last year.

A major driver of returns since the COVID lows of February 2020, has been a small cohort of technology/communications companies. ‘Mega technology’ companies like, Amazon, Microsoft, Facebook, and Alphabet (or Google) have outperformed the larger Nasdaq index. These are all large-cap companies with solid earnings streams and structural growth stories. Interestingly however, we have also seen ‘unprofitable technology’ companies (as measured by Goldman Sachs in a basket of 51 stocks) growing even faster and have surpassed mega tech over the last few months. Driven by low interest rates and a search for growth (and a healthy dose of ‘Reddit’-style induced retail speculation no doubt).

Through to the end of February, the Nasdaq index has declined by 7% since the highs reached earlier in the month, with the broader S&P 500 index hardly changed. This compares to the 16% selldown seen across the unprofitable tech index, which has less valuation protection when inputs like higher discount rates occur. The recent market moves are again a good reminder of the risks associated with investing in ‘expensive’ growth stocks, where the lofty valuations are not wholly supported by their realistic earnings growth outlook, even if they are solid companies. Valuations always matter eventually (as well as earnings). Picking the timing is difficult.  

Elfreda Jonker is client portfolio manager at Alphinity Investment Management.