Selectivity Is Key as Uncertainty Persists

As we have communicated recently, we believe the stimulation provided by central banks and, to an extent, governments has helped to partially offset the current, sharp economic contraction and stabilise financial markets. While the level of macroeconomic data and investor sentiment remains negative, they are no longer deteriorating. At the same time, valuation opportunities have opened up across assets, although care must be taken given the unprecedented nature of this shock. Uncertainty remains high as re-opening economies contend with the likelihood of a second wave of COVID-19 and we do not think that now is the time to re-risk wholesale. Instead, we are focusing on selectivity and discrimination, especially within growth-oriented assets. Among our key dynamic views is a preference for “quality growth” equities, as we believe these firms are well suited to weather the current storm.

What’s Next?

Levels and changes

Let us not mince words: the global economy is experiencing an unprecedented shock and a resolution remains uncertain. With another 3m new people in the US filing for unemployment and nearly 23m still without work, it is difficult to say we are out of the woods. However, the dynamic matters as much as the level for financial markets, and it is painting a rosier picture:

• In the US, the Empire Manufacturing Survey on General Business Conditions improved markedly from last month (-48.5 vs -78.2) and beat its recovery expectations (-60), while the University of Michigan Sentiment Survey also rose from its depressed level (73.7 from 71.8); 
• In China, many factories are back up and running, and urban transportation in the major cities looks to have recovered. Indeed for our Chinese Growth Nowcaster, the majority of underlying data (55%) is now improving, a notable change from last month; 
• Globally, while the Citi Economic Surprise Index remains negative, it has improved off its lows at the end of April. Our own surprise index covering the G10 economies remains depressed, but 48% of the data is currently improving;
• Our Global Growth Newscaster, which assesses news reporting on economic growth daily, has also seen a major change: it now shows a clear improvement, with 57% of its data improving versus a month ago.

Where to put on risk: “quality growth” stocks

In our view, now is not the time for a significant re-risking of assets across portfolios. Market volatilities remain elevated and there are too many unknowns about the pace, extent, and breadth of the economic recovery. However, given the stabilisation of financial markets, we do believe now is an opportune time to take on risk selectively. Put another way, it is the time for alpha, not beta.

One of our key views over the near term is a preference for “quality growth” equities. For us, quality stocks are those that have both strong income statements and balance sheets. Hence, among the factors we consider are firms’ earnings and sales growth, their profit margins and free cash flow, as well as their leverage ratios and return on equity (ROE). Given the massive uncertainty around the crisis, we believe these quality companies should have a strong enough cushion both on the earnings and funding side to ride through the current storm and emerge on the other side ready to benefit strongly from the recovery.

The numbers speak for themselves

In the case of the US, this translates into a preference for the Nasdaq 100 index over the S&P 500. In addition to possessing superior sales growth, the firms in the Nasdaq have seen profit margins average nearly 1.5x those of the S&P 500 over the last five years. They also maintained their superior margins during the depths of the GFC, which has helped them to retain earnings growth well above that of the S&P 500 (12% vs 7% average over last five years and -5% vs -24% on average from October 2008 to December 2009). Free cash flow on a per–share basis is also much stronger for the Nasdaq, though it comes at a price: free cash flow yields are similar for both indices. However, the balance sheets reveal a massive divide: the aggregate net debt–to–EBITDA ratio of the Nasdaq is nearly a tenth of that for the S&P 500 (0.17 vs 1.59). All of this translates into an average ROE of nearly 21% for the Nasdaq versus 14% for the S&P 500 over the last five years (and estimated to be 27% vs 18% over the next twelve months).

To be clear, our view is not just a preference for technology stocks: in Europe, we like the Swiss Market Index (SMI) over the Euro Stoxx 50. While sales growth has been higher for Euro Stoxx 50 firms over the last five years, the margins for SMI firms is much better in aggregate (9.5% versus 6.5% average over last five years), including during the GFC and Eurozone sovereign debt crisis. Even when the SNB let the Swiss franc appreciate at the end of 2014, margins remained superior to those of the Euro Stoxx 50, even if they did come down from their elevated levels. This has helped firms in the SMI keep profit growth in line with Euro Stoxx 50 firms (and surpass them over the last year). Free cash flow on a per–share basis is far higher for the SMI but, like the Nasdaq, comes at a cost as free cash flow yields are similar. In terms of leverage, the net debt–to–EBITDA ratio for the SMI is a third that of the Euro Stoxx 50 (2.0 vs 5.4). ROE over the last five years has averaged 11% for the SMI vs 9% for Euro Stoxx 50, while estimates put the next twelve months ROE at 13% for SMI and 9% for Euro Stoxx 50.

Risks to these exposures are manageable in our view

Our preference for these exposures is not without risk (otherwise, everyone would do the same). Firstly, valuation is clearly a risk: the 12-month forward price-to-earnings (P/E) ratio for the Nasdaq is 25.0 vs 20.4 for the S&P 500. Even considering the fact that the Nasdaq typically has a higher valuation than the S&P 500 doesn’t change the picture: relative to their own histories, the current Nasdaq P/E is at its 95th percentile vs the 90th percentile for the S&P 500. The SMI’s P/E currently stands at 16.4, above the 14.6 for the Euro Stoxx 50, though the picture is better relative to their histories (SMI is at its 87th percentile while the Euro Stoxx 50 is at its 96th). Moreover, there is the risk of crowded positioning, as both the Nasdaq and SMI have outperformed against the S&P 500 and Euro Stoxx 50 on many horizons: 5y, 3y, 1y, YTD, 2020 pre-coronavirus (Jan 2020 – 19 Feb 2020), coronavirus crisis (20 Feb 2020 – 23 Mar 2020), and post–coronavirus crisis (24 Mar 2020 – 15 May 2020). Interestingly, our measures of speculator net positioning in the Nasdaq vs the S&P 500 is more positive, as they seem to be less exposed to the Nasdaq than to the S&P 500 than they have been recently.

There are also idiosyncratic risks that we are exposed to and hence are carefully monitoring:

• Regulation of the US tech industry would hit the Nasdaq much harder than the S&P 500, given their constituents and weighting. A Democratic president and/or Democratic control of the Senate would seriously increase the probability of this risk, but with the election some time away and Washington focused on the current crisis, this is not at present an immediate risk in our view; 
• Like any index of global firms, the SMI is exposed to currency moves, and the Swiss franc remains a favourite safe haven. A resumption of a risk-off mode among investors would likely put further pressure on the franc to appreciate, which would be a headwind for Swiss corporate profitability; 
• Both the Nasdaq and SMI are exposed to concentration risk: just four companies account for 50% of the Nasdaq market cap (Microsoft, Apple, Amazon and Google) while for the SMI, Nestle and Roche alone account for just over half of the index. The situation is a little better for the S&P 500 and Euro Stoxx 50, though they are also somewhat concentrated in a few big names. However, those names matter: for the Nasdaq, they are all high–quality firms that are well positioned to thrive during the crisis (e.g., all have robust cloud services). For the SMI, Nestle’s dominance in consumer staples and Roche’s pharmaceutical business (followed by the next largest company, Novartis) are precisely the exposures one wants to hold. Compared to the exposures to financials, oil, and industrial manufacturing that you bear by holding the S&P 500 or Euro Stoxx 50, the company-specific risks of the Nasdaq or SMI are not so unattractive.

Finally, it is worth noting the secular trends that continue to benefit these firms disproportionally, including the digitalisation of many sectors of the economy, the emergence of winner-takes-all dynamics in industries, and the increasing health care needs of a large, aging population. These trends provide further tailwinds that should bolster the firms in the Nasdaq and SMI above others.

Staying neutral overall but on the hunt for opportunities

Our overall stance is one of neutrality: the macro situation is bad globally, and while we see a slowly improving picture, it is too early to be heavily exposed to risky assets. Investor sentiment remains negative, and so if conditions continue to improve, a swing in sentiment could add fuel to risk asset prices. In the meantime, valuations remain uneven across assets, suggesting upside in some cases (equities) and downside in others (real assets). In this context, we think selectivity and discrimination have a critical role to play in asset allocation.

Unigestion Nowcasting