Unlike our equity index targets, markets have been on a rollercoaster ride in the year-to-date. The recovery in share prices since March has certainly been faster than we expected. We would attribute this to a combination of a health crisis unprecedented in recent economic history that has been accompanied by equally unprecedented monetary and fiscal stimulus measures. In such an environment, it is naturally difficult to assess the current value of highly uncertain future earnings streams that, in theory, underpin market valuations.
Against this backdrop, we are leaving all of our 12-month index targets unchanged from our last review meeting. Those were 3,100 for the S&P 500 and Dax 12,000, to cite two prominent examples. We will leave it to you to calculate the likely price returns until June 2021 by the time you read this. At the time we made our decision, our targets translated to mid-single-digit total returns over the coming 12 months – or roughly what markets have been gaining or losing on a weekly and sometimes daily basis in recent months.
In such an uncertain environment, we believe a disciplined approach is crucial. We feel that we have sufficiently stretched our fundamental valuation models in deriving our index targets. Driven by falling interest rates we have increased the warranted price-to-earnings multiples for the global lead index – the S&P 500 – from 16 times earnings in 2013 to about 20 times expected earnings. Lately, the Covid-19 pandemic has compelled us to extend the time horizon for our earnings per share (EPS) forecasts as well, from 2 to 3 years. This was necessary in order to capture the pandemic and lockdown-related EPS collapse in 2020 and subsequent expected sharp profit recovery until 2022. It is worth noting, however, that most companies have suspended their guidance during the past few months, making all EPS forecasts highly uncertain. As we apply a very generous discount rate to highly unpredictable earnings streams, we feel that equity markets may have gotten ahead of their fundamental prospects.
This need not necessarily translate into quick and dramatic setbacks of the sort markets experienced in March. Nor does it rule out markets overshooting further on the way up. After all, monetary and fiscal policy remain ultra-loose. Leading indicators should turn positive shortly and many workers who recently became unemployed are likely to find their way back to the labor market during the coming months. However, the downside risks for the economy and earnings remain considerable. To name only a few: a renewed surge of Covid-19 cases might require a second wave of lockdowns; the timing and effectiveness of the various fiscal stimulus programs are uncertain; lower interest rates will continue to pressure bank earnings; U.S.-Chinese tensions remain a burden; and, last but not least, the upcoming U.S. election introduces plenty of uncertainty in terms of U.S. economic policymaking.
Among these risk factors, our most crucial assumption is that a second wave of lockdowns can be avoided in most industrialized countries. Partly, this reflects our growing confidence that populations and policymakers are rapidly learning how to deal with the pandemic in less economically damaging ways. To again list just a few examples, testing capabilities are much improved. In most countries, wearing masks is becoming increasingly common. Hospital capacities have been expanded and will probably be upgraded further ahead of this year's flu season in the Northern hemisphere. All this should help alleviate the need for a second round of broad-based lockdowns in the face of renewed outbreaks. While the above describes the situation in the European Union and parts of Asia quite well, however, we are less confident that the first wave has already been contained in the United States. There, it is quite possible that we could see further lockdowns at the municipal or state level, or alternatively, consumers might themselves decide to stay at home. Moreover, the pandemic continues to spread in many emerging markets. So for the world as a whole, it is still premature to talk about second waves – for now, the first one has not even crested yet!
Partly as a result of all these uncertainties, we do not express a strong regional preference. Instead, we favor a well-diversified global portfolio with a meaningful share invested in emerging-market equities and a bias towards "quality" (i.e. with little debt and resilient cash flows) companies. We believe this should offer the best balance of risks and reward prospects for long-term equity investors, especially when combined with selectively buying high-quality names during periods of market turbulence.
Regarding sectors, we have long favored growth stocks compared to value stocks. We continue to like segments with solid long-term prospects, including in the technology and health-care areas. During the current crisis digitalization trends have accelerated further. In particular, office workers and their employers have gained plenty of firsthand practice in working from home. This is likely to lead to change in how they work much more quickly than might otherwise have been the case. Contactless payments and efficiency initiatives may also provide additional support to the IT sector. Health care should continue to benefit from its structural defensive-growth characteristics and may get additional support from more investments in health systems.
That said, we do believe that the expected economic recovery will eventually favor some attractive "value" and "cyclical" stocks to temporarily outperform. As a result, we have already started to weaken our growth bias somewhat. Notably, we have recently raised the materials sector to neutral. Mining companies, in particular, should benefit from rational pricing, stable Chinese demand for iron ore and copper and resulting attractive free-cash-flow yields. This is in striking contrast with oil markets, where OPEC producers continue to jockey for market share with each other and producers from other countries. It also highlights the need for a selective approach, combined with an in-depth understanding of relevant sector dynamics. Similarly, we expect some of the stocks in the highly cyclical machinery industry to outperform as leading indicators are improving. We remain underweight in utilities, due to subdued growth prospects, and are downgrading real estate to underweight, with shopping malls being challenged by e-commerce and office real-estate investment trusts (REITs) suffering from "working from home." In our view, selection and active management will be key in coming months – whether at the country, sector, or company level.
United States: neutral (neutral*)
Compared to most industrialized countries, the U.S. has been less successful in containing the pandemic thus far. In the recovery phase, U.S. equities may nevertheless benefit from a more flexible and dynamic jobs market, a large number of technology mega caps, and outsized U.S. fiscal and monetary stimulus, easily outpacing European economic emergency-relief measures. Given recent stock-market strength, a lot of hope is already priced in, leaving scope for short-term disappointments.
Europe: neutral (neutral*)
Investor positioning in European equity markets remains quite low. This suggests scope for further upside in companies able to deliver solid second-quarter earnings, or at least reassuring guidance on the likely slope of their earnings recovery. Meanwhile, the new EU recovery fund marks the first sizeable mutualized-debt-issuance program, which may make the common currency less prone to future crises. Risks abound, however, including no trade deal between the UK and the EU being reached.
Japan: neutral (neutral*)
In the current crisis, earnings and dividends of Japanese companies have been much more resilient than in most countries. Partly, that reflects the success of public-health authorities in containing the pandemic, albeit after a slow start. Solid balance sheets have helped and many companies would be well positioned to benefit from a world-wide economic rebound. The reverse, alas, is also true, if global trade stalls or geopolitical risks rise, for example due to rising tensions with China.
Emerging Markets: neutral (neutral*)
Many emerging markets have been badly hit by Covid-19, with Brazil, India, Russia, Mexico and Peru among the most prominent examples. Moreover, it remains too early to say when and at what cost the pandemic can be contained. Even in China, the discovery of new clusters of cases at a Beijing wholesale food market has brought back the specter of further disease waves. Renewed tensions with the U.S. over Hong Kong, as well as China's border conflict with India, have not helped matters either.
Sources: FactSet Research Systems Inc., DWS Investment GmbH; as of 6/17/20
* Our assessment is relative to the MSCI AC World Index, the last quarter's view is shown in parentheses
Appendix: Performance over the past 5 years (12-month periods)
|05/15 - 05/16||05/16 - 05/17||05/17 - 05/18||05/18 - 05/19||05/19 - 05/20|
|MSCI AC World Index||-7.4%||15.2%||9.7%||-3.3%||3.5%|
|MSCI Emerging Market Index||-17.6%||27.4%||14.0%||-8.7%||-4.4%|
|MSCI Japan Index||-8.2%||15.0%||14.6%||-10.0%||7.0%|
|Stoxx Europe 600||-10.0%||16.1%||1.5%||0.0%||-2.4%|
Source: Bloomberg Finance L.P. as of 05/31/20
Past performance is not indicative of future returns. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.