In a year of economic recovery, the risk/ reward ratio is generally favourable to equities. Although some countries, particularly in Europe, are still in lockdown, the month of January is starting well with the release of the vaccines, the Brexit deal, and a Democratic victory in the US Senate conducive to a major recovery plan.
- Equities will benefit from a strong recovery in profits
With global growth expected to amount to more than +5% in 2021, global profits should rebound by more than +25% (Chart 1). The economic cycle has only just begun, and the growth phase will be spread out over several years. Market indicators corroborate this constructive vision. The dollar is weakening, which is contributing to the rise in inflation expectations in the United States, expectations that are themselves correlated to the cyclical/ defensive ratio and to industrial raw materials prices, the latter itself being a proxy for trends in global profits.
- Part of the recovery in profits will be absorbed by a decline in P/Es
Equity markets anticipated an economic recovery as early as 2020 following the strong support of central banks and governments and the November announcement of the arrival of the vaccines just after the US elections. As profits fell at the same time, P/Es rose to extreme levels, sometimes to levels not seen since 2000, with a notable difference between the two periods. The 2000 PERs referred to topof-the-cycle profits, whereas current PERs are based on bottom-of-the-cycle profits. The recovery in profits will therefore be partly consumed by a fall in P/Es. However, liquidity provided by the central banks and the low interest rate context will allow PERs to remain at sufficiently high levels to allow equity prices to rise between +5% and +10% over the year.
- The climax of volatility was reached in 2020 and flows should now favour equities
Historically, volatility tends to decrease as profits recover. It is also a function delayed from 18 months to two years in the evolution of monetary policy (chart 2). The high point of Fed rates having been reached in 2019, It is therefore highly likely that volatility will fall structurally in the months and years to come.
This should encourage a return of flows to equity markets, especially as high yield spreads have tightened, and alternatives for risky assets are therefore less generous.
- Risks are of course still present, but the risk/reward ratio is favourable
There are three kinds of risks. By far the most dangerous would be doubts cast on the vaccine’s effectiveness and an uncontrolled resurgence of the virus. Beyond this black swan, a second type of risk would be a delay in the economic recovery (caused by lockdowns, delayed vaccinations, etc.). This would rather create opportunities insofar as central banks and governments remain supportive.
Finally, the third type of risk consists, on the contrary, particularly in China and/ or the United States, in the possibility that the recovery would be sufficiently underway to envisage a withdrawal of support. However, while central banks may well end up being tested by the markets in this respect, it is likely that their initial response will be rather reassuring.
- How to apply this pro-cyclical approach in an equity portfolio?
In terms of style, small caps are a great candidate. This asset class, which always outperforms at the start of the cycle, has already rebounded well, but its potential has not yet reached its limits. As for the Value style, which is lagging behind other cyclicals, it offers attractive potential for catching up. Finally, economic recoveries are usually not favourable for quality stocks, but given the low level of rates and the ongoing disruption, we believe that this style, as well as ESG equities, constitutes a valid complement to cyclical stocks to balance the risk of a portfolio, by accepting a longer-term investment horizon and as long as it is not overpaid. Geographically, this is reflected in a preference for emerging markets especially since currencies have broken out against the US dollar. However, Japan and the euro zone, also cyclical and value, should also do well at least initially.