Post-Pandemic Equity Investing

The Strategic View

21 September 2020

8 min read

Inigo Fraser Jenkins| Co-Head—Institutional Solutions

There’s no doubt the COVID-19 pandemic has thrown a great deal of uncertainty into markets when viewed through a near-term, tactical lens. But looking beyond that time frame over the next several years, what are the strategic takeaways for equity investors?

Not Just About Sector Cash Flows

This isn’t simply a question of looking at the impact to industry business models in the post-pandemic world. Investors need to assess equity markets from multiple dimensions that collectively will shape relative sector performance.

For one thing, we think real interest rates will stay low and that the COVID-19 policy response will be inflationary. In our view, the entire policy reaction function has shifted to a fiscal-monetary combination that departs from the macro framework of the last 30 years. A reaction against the shareholder-first capitalism of the last 30 years also seems likely, given the added pressure from higher unemployment and sharply higher inequality.

The US election outcome will clearly influence this aspect in the near term, but beyond the current election cycle and considered globally, tax rates seem destined to rise. It also seems likely that policies will shift bargaining power back to labor, which could influence labor-heavy industries where pay is lower. And the model of levering up corporate balance sheets for share buybacks may come into question.

New Patterns of Asset-Owner Demand

Real returns will likely be lower, finding income will be a challenge and stock-bond diversification may not be as effective as it has been. As a result, equity investors may need to adopt a cross-asset perspective for many sectors. As assets shift out of high-grade fixed income, sectors that benefit as inflation rises, those that can deliver sustainable dividends and those that offer long-term access to real growth are likely to see more interest.

One sizable issue for asset owners? Nearly all assets—stocks, government bonds and credit—are historically expensive right now, and valuation spreads are extreme by some measures (Display). From a strategic perspective, how much of this valuation spread can mean revert? The outlook for a prolonged period of low or negative real interest rates implies that at least some of the spread may not revert in the near term, though there are elements of value cyclicals that may benefit from this.

Valuation Spreads Haven’t Been This Extreme in Decades

Nearly all assets are historically expensive right now, and equity valuation spreads are extreme by some measures. For example, the spread between the most expensive and cheapest stocks hasn’t been this wide in over half a century. How much of this spread can mean revert?

Comparison of inverted trailing earnings yield for expensive and cheap stocks since 1951

Through August 31, 2020
The historic series, derived from the Ken French Data Library, is the market-cap weighted 12 months trailing P/E ratio for the most expensive and cheapest quintile of stocks from among the largest 1,200 US stocks. The latest data points are estimates derived by Bernstein Research based on current valuation data. Stocks with negative trailing earnings are excluded.
Source: Bloomberg, FactSet, Ken French Data Library, MSCI and Bernstein Research

Another sizable change in investor demand is likely to come from environmental, social and governance (ESG). We think that much of the active management approach to ESG will focus on engagement, which lends itself more to stock-level investing rather than broad sector conclusions. Part of this will be a shift away from buying companies that are already “good” toward those that can improve, in order to make real change. Cheap passive implementation (smart beta) will be more relevant for asset owners looking for broad access to individual themes such as decarbonization.

So how do these trends translate into sector implications over the strategic horizon?

Tech, Healthcare and Growth Consumer Cyclicals

With real rates anchored at low levels for a long time and with more persistent growth and profitability for high-growth and high-profitability companies, long-duration equity sectors can maintain high valuations. Yes, US growth stock valuations have risen above average relative levels of the last decade, but the valuation spread between high- and low-growth stocks is still far from its historical extremes, and discount rates are far lower than they were in the previous 2000 peak.

There’s more to the issue than justifying the valuation of growth stocks—there’s also a question of demand. Corporations themselves have been the main source of equity demand for the past 10 years via buybacks. While buybacks are currently suppressed, when they bounce back tech seems likely to lead. Moreover, if antitrust concerns make it hard for tech companies to conduct M&A, this would also support buybacks.

The macro risk for growth stocks is the potential for a change in policy regime—in other word, a move to tighten perceived antitrust and privacy issues, a continued trend of deglobalization and tax changes. Tech and healthcare are the two sectors in the US that have benefited most from being able to lower their effective tax rates over the last decade.

Consumer Staples: Income and Real Growth Potential

We think the staples sector is one where the cross-asset lens makes the most sense, because of its ability to deliver an income stream and its claim of positive real growth potential in the long term.

The spread between staples’ dividend yields and bond yields has never been wider. Unlike more cyclical or financial sectors, there is evidence that these companies can maintain this level of dividend and also see it grow in real terms. The pushback against why individual equity securities can be seen as part of a replacement for fixed income is that they’re more “risky.”

Yes, in a sense that remains the case, but some elements of this stance are less clear than they perhaps were historically. The duration, and hence interest rate risk, of high-grade fixed income is higher than it’s ever been before. As a result, bonds are likely to be a less effective diversifier of equity risk. Also, in an age when elements of Modern Monetary Theory–like policies are on the table and the age of Pax Americana is over, it’s not even clear that there’s such a thing as a risk-free asset.

If we’re right in our call that inflation is set to rise in the coming years, consumer staples, along with healthcare, tends to be the sector with the best return/risk trade off (Display). Note: this comparison unfairly punishes tech; for most of this period, tech was very different from how it looks now.

US Sector Relative Return and Risk With Inflation Over 3%

If inflation is set to rise in the coming years, some sectors will likely be better equipped to outperform than others, based on history. For example, consumer staples and healthcare have delivered the best risk/return tradeoff when inflation has been over 3%.

A comparison of sector returns relative to the market and risk levels when inflation is over 3%

As of July 31, 2020
*Relative year-over-year return of sector vs. the market when average inflation (CPI) during the year was above 3% from 1973 to 2019.
Source: Datastream and Bernstein Research

Consumer and Industrial Cyclicals: The Easiest Case for “Undervalued”

As we mentioned earlier, there’s controversy around the question of whether the wide valuation spread across equity markets will close. Will mean reversion drive sector returns? There are structural reasons why the valuation factor—broadly defined across a blended collection of valuation metrics—hasn’t worked in recent years, such as declining bond yields that have impeded mean reversion and the switch of corporate investment from tangible to intangible assets.

But one key missing piece has been inflation. Over the past 90 years, the value factor has done best when inflation has risen, and inflation has persistently disappointed on the downside over the last five years. If inflation is now set to rise, is this the key support pillar for value that has been lacking? And if so, should investors be buying cheaper value sectors? We think there has to be a differentiation between kinds of value trades.

Perhaps the easiest case to make is for “undervalued,” as opposed to simply being low-multiple, industrial and consumer cyclicals. These names may derive support from a longer-term recovery in inflation expectations. Thus, an eventual recovery means that investors can take a value position in select subsectors, including airlines and hotels. Also, within industrials there’s a group of automation names that we think have a structural case for growth. With deglobalization likely to be a persistent feature, activity bought back onshore is likely to be heavily automated.

Energy and Mining: Commodity Cyclicals Offer Inflation Protection

A second area of value cyclicals that we think could benefit from inflation and long-run mean reversion are commodity cyclicals. For investors who think that the inflationary effects of the policy response to COVID-19 will be inflationary sooner rather than later, there’s a case to be made for an overweight to these sectors.

In some cases, there’s been a painful downward adjustment of dividend levels within energy and mining. But if we assume that the greater capital discipline of recent years can be maintained, then the level of dividend yield that now prevails in the sectors also leaves them looking attractive from a cross-asset income perspective.

Banks: No Yield-Curve Steepening Blunts Inflation Benefit

We expect a disconnect between the financial and nonfinancial components of the value factor.

Banks have tended to respond very well to inflation increases historically, but increases in inflation are usually accompanied by or followed by a steepening yield curve. This time, we don’t think that will happen. The announced shift in policy makes it clear that rates will stay low even if inflation rises. Moreover, that policy could be further adapted to more tightly control the yield curve if need be.

In our research, we can unstitch the impact of inflation and the yield curve using simple bivariate regressions. Depending on the definition of inflation used, inflation either loses its explanatory power for banks’ performance when considered alongside the yield curve, or at best is equal with the yield curve. The bottom line: without a steepening curve, inflation is a less powerful support for banks’ relative performance.

There’s also the question of bankruptcies. We think that there’s an extended bankruptcy cycle still to come. It has been blunted by policy support, but at some point it still needs to happen. We also worry that ultimately banks may not be masters of their own destiny, given their key role in directing credit.

Real Estate and the Equity Diversification Question

In theory, an investor being told that a period of higher inflation is coming and that real returns are low would typically respond by allocating a much higher exposure to real estate, because that sector performs better when inflation rises. However, we think asset owners will be forced to hold a higher strategic equity exposure if the prospect of real returns elsewhere is low and inflation rises.

If bonds are no longer as effective a diversifier, other parts of the portfolio will be needed to help diversify the overweight equity position. REITS have a correlation with equities that rises with inflation, so are unlikely to be good diversifiers. In addition, the fundamental outlook for large parts of the real estate sector that have exposure to central-city office spaces and retail malls may be impaired by changes in work patterns post COVID-19.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

About the Author

Inigo Fraser Jenkins

Inigo Fraser Jenkins is Co-Head of Institutional Solutions at AB. He was previously head of Global Quantitative Strategy at Bernstein Research. Prior to joining Bernstein in 2015, Fraser Jenkins headed Nomura's Global Quantitative Strategy and European Equity Strategy teams after holding the position of European quantitative strategist at Lehman Brothers. He began his career at the Bank of England. Fraser Jenkins holds a BSc in physics from Imperial College London, an MSc in history and philosophy of science from the London School of Economics and Political Science, and an MSc in finance from Imperial College London. Location: London

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