A balancing act

The beginning of the year has been very supportive for risky assets. Equity markets have continued to progress, and several equity indices in Europe and the US have hit all-time highs. Market leadership, however, has changed during the last few months.


03/06/2021 – Olivier Raingeard

While the US equity market remains the leader, European equity markets have improved, with a high correlation with the US. Japanese and emerging-markets equities are lagging. For investors, the two main questions regarding equities are the following: are valuations too stretched to justify further upside? Are the rotations between cyclicals versus defensives and value versus growth sustainable?

Are valuations too stretched to justify further upside?

Valuations can be looked at from different angles. Absolute valuation metrics, such as the price-to-earnings ratio or price-to-book, clearly look stretched. The price-to-earnings ratio on realised earnings has reached 25, significantly higher than the long-term average of around 16. The price-to-earnings ratio based on forward earnings is above 20, again higher than the historical average (see Figure 1). Even the cyclically adjusted price-to-earnings ratio looks stretched. Nevertheless, there are also other ways to look at valuations, in particular when we compare one asset class to another. The so-called equity risk premium, which compares equities to bonds, provides a more supportive outlook for equities.

Afbeelding Figure 1

Source: Bloomberg, Datastream

Furthermore, valuations are not always a good indicator for managing a tactical asset allocation. Other factors, such as the economic and monetary environment should be considered. World economic growth will be above its potential in the coming two years, fed by the reopening of economies and the support from fiscal and monetary policies. As a consequence, earnings growth is going to be extremely strong. The first quarter is already providing evidence of this. For the S&P 500 Index, earnings growth is around 45% and much better than expected. Looking forward, there is a high probability that earnings will remain better than expected (see Figure 2). Even though some pricing pressures could hurt margins, there are more than enough reasons to remain overweight on equities.

Afbeelding Figure 2

Source: Bloomberg, Datastream

Cyclical versus defensive and growth versus value?

The second debate concerns sectors and regional positioning. One question is related to the cyclical exposure that portfolios should have during a recovery phase, but the biggest debate concerns the balance between growth and value stocks. Regarding the cyclicality of portfolios, we believe that the recovery phase justifies holding an overweight in the materials, industrials and consumer discretionary sectors. These sectors are expected to benefit from the acceleration of the world economy through consumption and production. On the other hand, we underweight the energy sector, given the long-term issues that it must deal with. We also underweight the consumer staples sector, which is one of the most defensive sectors.

We have adopted a balanced position regarding the debate of growth versus value. The financials sector is overweighted, as it will benefit from a cyclical recovery and a steeper yield curve – in particular in the US – that should support earnings growth. Growth sectors and, in particular, information technology (IT), are no longer overrepresented within our portfolios. Since September 2020, we reduced the position in IT to neutral, given that we expected other sectors could do better in the coming months. Nonetheless, the digitalisation trend, in terms of how we produce and consume, should continue to support this sector’s secular growth.

Given that we expect the global economic recovery to support all regions, we have a broadly neutral stance regarding regional equity markets in the US, Europe and emerging markets. 

Olivier Raingeard – Global Head Equities

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