Economic Update: Will the Rotation to Value Continue?
Chris Watling, Longview Economics
The outlook for 2021... and beyond
The mood in markets has shifted dramatically in just the past three months.
Successful vaccines, the passing of the US election and an increasing belief in strong global growth in 2021 have all come together to spur global equity markets and risk assets higher over the past few months. Indeed, the pattern of the global rally illustrates the marked shift in leadership since late October last year (the latest local low in global equity markets, and just prior to the US election).
Since then, European and emerging market equities have risen over 20% (i.e. in approx. 2 1/2 months); the US mid-caps are up around 35%, while key cyclical sectors (like global financials and energy) are 32% and 51% higher respectively. Tech, meanwhile, is lagging and only up between 14% – 16% (NASDAQ100 & global IT sector respectively).
In other words, the rotation from growth into value has been happening in a dramatic fashion over the past two months.
The key question now, therefore, is: Will that continue? And if so, for how much longer? And, what will drive the rotation going forward? Indeed, the global economy looks set to boom in 2021 but what will happen post 2021, when the sugar high of the stimulus begins to fade? What, if anything, will drive the global economy forward from 2022 onwards? And finally, and most importantly, how will markets behave in that environment?
The underpinnings of strong growth in 2021
With vaccines now being administered across the major western economies and other emerging economies, a boom in economic growth in 2021 seems all but assured and is now the consensus. Wartime levels of fiscal and monetary stimulus have been brought to bear on the global economy. In the US, the Federal Reserve did as much Quantitative Easing in 6 months last year, as it did over the course of the first 6 years of the recovery from the GFC (i.e. from late 2008 through to end of 2014). The US government is expected to enact its third major1 fiscal package shortly after Biden’s inauguration (with a US$1.9 trillion package proposed by the President). That will come swiftly on the heels of the $900 billion program just passed over the Christmas holidays. Other countries across the globe have also been aggressive with their policy stimulus in 2020 (albeit the US has enacted one of the largest packages relative to GDP).
The result, as is well known, is that households in most countries have built up high levels of spare cash balances in bank accounts. In the UK, for example, Q2’s household savings ratio was 26.5%. That’s almost twice its highest peak in the past 50 years. In Q3, it remained high at 16.5%. Indeed, we estimate that by the end of 2020, UK households had extra cash in their bank accounts equivalent to approximately 7.7% of GDP, brought about by forced savings during the pandemic and the resulting policy response. In the US, the equivalent figure is approx. $2.3 trillion (~11% of GDP). It’s neatly illustrated by the change in trajectory in 2020 of one of the key subcomponents of US M1 money supply (i.e. US demand deposits – see Figure 2 – which is cash in household and corporate current accounts).
Will it continue beyond 2021?
While it’s clear that the outlook for 2021 is strong (and, as mentioned, that’s now a consensus view), what is now more critical is whether strong growth momentum will continue beyond this year? How strong will growth be in 2022, 2023 and beyond?
In that respect, there’s a cocktail of three factors that are coming together which should provide continued momentum in the global economy once the initial ‘sugar rush’ stimulus wears off.
Those three factors are as follows:
1. Households have paid down considerable levels of debt during the pandemic (US credit card balances, for example, are down US$120 billion from their peak at the end of 2019). That frees up borrowing capacity which can be tapped into to drive further consumption growth.
As the world economy normalises, therefore, we expect the Western consumer (especially the US, and other Anglo Saxon consumers) to resume their high marginal propensity to spend! That effect, coupled with falling household savings ratios (the norm in the initial few years of recoveries), should provide a strong underpinning to consumption growth (a credit multiplier effect).
2. The trend in housing and house prices should remain strong. As in the US recession in 2001, US housing last year (and indeed global housing) remained robust despite a major equity bear market and economic recession. After an initial 1 – 2 month wobble in house prices at the height of the lockdown, most countries’ prices resumed a strong upward trend for the remainder of 2020. That reflects monetary looseness, plentiful liquidity and some one-off specific factors (e.g. the ‘Zoom’ effect).
In that sense, therefore, house prices are following the usual pattern of the 18 year land cycle. That cycle has been established in the US economy for the past 200 years (as well as in the UK). It typically encompasses an initial four year down cycle in prices (i.e. most recently from 2006 – 2010), which is then followed by 14 up years (i.e. 2010 – 2024). If repeated, then housing should remain strong through to 2024 or so.
A house building boom should also ensue, given that there is currently a record low supply of unsold US homes (i.e. at 3.5 months).
The uptrend in house prices should then drive growth in home equity withdrawal, thereby supporting strong consumption growth in 2022 and beyond. Of note, already in 2020, home equity withdrawal has picked up sharply (Figure 4).
3. Underpinning increased borrowing and a strong housing market, US and global monetary policy should remain looser for longer. While there are some concerns about some removal of monetary accommodation later this year, and into 2022, the tone of the key Fed governors remains resolutely dovish, whilst unemployment rates remain elevated. Indeed in his latest comments, Chair Powell said that the Fed was far from considering an “exit” from its ultra-loose monetary policies and that “[One] lesson of the global financial crisis is: be careful not to exit too early and by the way, don’t try to talk about exit all the time ... because the markets are listening.”
How will markets react?
If correct, then those macro trends support a structural shift into value and cyclical stocks with the growth sectors no longer providing the leadership in global equity markets (as they have done in recent years).
That expectation is backed up by the extreme relative price performance and relative valuation that has built up over the past few years. As Figure 5 shows the relative valuation premium of growth over value stocks is back at the extreme levels last seen in the Dot-com bubble and prior to that in the mid-1970s ‘nifty fifty’ bubble in growth stocks.
As such, a handful of years with value/cyclicals outperforming growth, much like the noughties, is our central expectation. A strong housing market supporting strong consumption and economic growth (as well as some inflation) should underpin that expectation. In scarce economic and earnings growth environments, investors assign higher valuations for secular growth (i.e. growth stocks). When growth becomes broader based, and more widespread (as is likely over the next few years), investors don’t need to pay as much of a premium for secular growth (i.e. given growth is more readily available). In those environments the valuation gap closes between growth and value stocks.
What are the risks?
Naturally, though, there are multiple risks going forward. Anything which upsets the Fed’s plentiful liquidity provision is a concern, especially given the rich valuations in a variety of global equity markets. The S&P500, for example, is on a forward PE ratio of approximately 23x (consensus 12m forward earnings). This valuation has only been surpassed during the Dot com bubble and then not by much. It’s not just the US equity market which is expensive though, a significant majority of markets which we follow (i.e. over 30 across the globe) are in their top quartile valuation range. That includes the Brazilian, the Indian and the Australian stock markets amongst many others.
With liquidity a key driver of high valuations, the Fed will need to tread a delicate path as it attempts, perhaps in late 2022 and beyond, to withdraw some of that monetary accommodation. As such, anything that troubles the market on that front or encourages the Fed to move too fast is a concern. Hence we are watching inflation, amongst other factors, closely.
Absent inflation or other similar pressures, the Fed will be ultra-cautious once it begins to normalise policy, thereby leaving the support for equity markets in place and the value/cyclical sectors of the market likely driving prices higher.
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