Americas CIO View

A longer Covid-19 tunnel: prefer bond substitutes over recovery stocks

Most recovery stocks are priced for the best, yet some might still face the worst

Vaccines notwithstanding, we believe Covid-19 will severely disrupt the western world at least through spring and could return to Asia with variants more difficult to contain. The risk of global economic disruptions through 2021 and into 2022 from infection-prevention measures are rising in our view. We think the consensus for robust U.S. and global economic growth in 2021 requires careful scrutiny. We do expect even more fiscal support, but we see this as a transition from initial monetary-policy assistance (interest-rate cuts, eased financial conditions) to a series of fiscal packages needed to help the hardest hit survive a longer Covid-19 tunnel and stave off a stalled recovery or double-dip recession. The confidence and wealth effects from stocks and housing provided a big boost in 2020, but with limited further potential and at risk now to uncertainties from unprecedented fiscal/monetary actions and variant strains.

A longer Covid-19 tunnel to recovery suggests more new norms after the recovery

Covid-19 changed the way many people go to work, school, travel, eat, exercise, entertain themselves and think about their health, lifestyle and general wellness. Many moved or changed jobs by choice and without. Such changes might have been taken as temporary, but many will stick as they stretch beyond a year. There is likely some pent-up demand, such as for leisure travel, but the many changes also suggest demand shifts and capacity adjustment. It could take several years until business travel or big city daily office occupancy or full service restaurant dining returns to 2019 levels. The pandemic also changed American politics and similar to other periods of social crisis, it has brought calls for more safety nets and contributions from those that can do and pay for what must be done. These developments are posing uncertainties in the United States and elsewhere around the world.

We seek stability: raising consumer staples to overweight, lowering discretionary to underweight

We believe in the recovery, but it is priced. We see neither extravagant consumption nor pricing power ahead for most consumer-discretionary goods and service producers/retailers. We think consumers will seek and pay up for certain travel and live entertainment experiences. But goods still bought on best price/value, not indulgence or brand/status. Digital products and internet retailing will continue to take share from physical goods and onsite retailing. The price effects of world-trade tensions, local taxes, minimum wages/benefits, and also environmental concerns, older demographics and a bit of modesty are likely to temper goods-consumption trends and purchases made at many retail venues. Yet demand for household and food consumer staples will likely stay elevated at big-box value retailers. Moreover, earnings are stable with inflation protection and valuations are undemanding.

S&P 500 EPS reports: fourth quarter bottom-up climbs to 40.80 dollars, S&P 500 nears full recovery to peak

Fourth quarter S&P 500 earnings per share (EPS) looks likely to bring quarterly S&P 500 EPS very close to its prior peaks, putting full 2020 S&P 500 EPS at about 140 dollars and currently annualized S&P 500 EPS at about 165 dollars. The performance by sector and segments continues to follow the trend of strong recovery or best ever at the young & healthy and lagging recovery and some still deteriorating at the old & vulnerable. Banks joined the strong earnings recovery in the fourth quarter, but still well below 2019 profit levels, and in the third quarter and fourth quarter most leading large retailers, home- and auto-related firms did well too. The biggest laggards are energy, most of industrials, passenger transport, some traditional media/telecom and Real Estate Investment Trusts (REITs). But the goods producing nature of the S&P 500 provided a buffer against the broad shock to services and the S&P 500's digital technology and healthcare firms were well positioned to respond to the needs and shifts of the pandemic.

Greater S&P 500 EPS resilience: U.S. GDP -2.5% in 2020 4Q/4Q vs. S&P 500 EPS -15%

U.S. real gross domestic product (GDP) slowed more than expected in the fourth quarter to a 4.0% seasonally adjusted-annualized rate following 33% growth in the third quarter. Because of the March and April plunge, U.S. GDP still finished 2020 2.5% below 2019 end level. Full 2020 compares to an average U.S. recession of 2% contraction typically a bit over a year. In past recessions, S&P 500 EPS fell 20% year-over-year on average, this time 15%. A worse recession than usual, but greater S&P 500 EPS resilience. January seems to have brought more global slowing, in the United States, especially in Europe and even some in Asia. It is very possible that the pandemic weighs heavily on the recovery well into spring. And as the pandemic lifts, government borrowing to fund pandemic support will start to be repaid in the forms of moderately higher taxes, moderately higher real interest rates and inflation. We think it uncertain exactly when, where and how much the payback might be. But we expect some shared government balance-sheet repair and thus seek reliable earnings power, less demanding valuations and inflation protection outside oil.

 

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