2021 Outlook: Time for a great rotation in equities?
2020 has been a year that many of us will be happy to bid farewell. The COVID-19 pandemic has claimed more than a million lives globally and forced lockdowns and rolling restrictions on populations. This in turn caused an economic and financial market crisis, which has added to the human toll. While governments have delivered substantial monetary and fiscal relief to ease the economic pain, the economy has yet to fully recover. There does appear to be a light at the end of the tunnel, however, as we head into 2021. Aided by government programs, including Operation WARP Speed in the US, the private sector has delivered by developing effective vaccines (with unprecedented speed) that are in the process of being approved by regulatory bodies. It will be a challenge to produce, deliver, and distribute the vaccine at scale and inoculate a large percentage of the world’s population, but a return toward normalcy does seem likely for 2021.
While the economy has not yet fully recovered its losses, equity markets recouped their losses by late summer and have since decisively broken out to new highs. Wall Street strategists appear bullish on the prospect for additional equity market gains in 2021, and we agree with that judgment. Profit growth will likely be very strong next year, driven mainly by improvements in revenue growth and operating leverage (due to cost cutting during the downturn). Strong profit growth should drive equity returns next year as market price/earnings multiples are high and likely to decline. However, we think that decline in valuation will be measured and orderly and consistent with strong equity returns, given the still supportive backdrop on interest rates and inflation.
The bigger question for 2021 is which groups will be the leaders and laggards? That is, will we continue to see a market driven narrowly by secular growth names, or will we see a broadening of performance where more cyclical/value-oriented laggards take the baton of market leadership? 2020 stock market performance was clearly a story of “Big Tech.” Apple, Microsoft, Amazon, Google and Facebook—account for an unprecedented 22% of the S&P 500 index capitalization and have returned a mammoth 49.4% year-to-date through 11/30, while the rest of the S&P 500 constituents have returned a still solid but much lower 9.6%.
However, we have started to see market performance broaden out, and positive vaccine news, combined with a benign outcome in the US presidential election amplified that trend in November (see Figure 1) with energy, financials, industrials, and materials outperforming. Technology stocks still participated in the gains (and even beat the market by a small margin) but were not the big winners. Value stocks beat growth stocks and small-caps outpaced larger companies. EAFE markets beat US stocks. Emerging market stocks lagged US stocks but by a small margin.
Figure 1: November Brings Sea Change in Relative Performance
(Click image to enlarge)
We think this theme of broader market participation in the context of continued strong equity market performance could be an omen for performance in 2021. Next year may not be a raging value market (though it could be), but the “reopening trade” (dominated by cyclicals and value stocks) should, at a minimum, vie with the “secular growth trade” for leadership.
Even before the pandemic, the US and, to a lesser extent, the global economy, were already undergoing big structural changes driven by increased adoption of technology/digitalization. However, the lockdowns and quarantine measures earlier this year forced entire populations to work, shop, socialize and attend school online. This intensified the use of cloud platforms, internet services, and 5G wireless networks, turbocharging the performance of the related industries and stocks this year. An August study by Mckinsey noted that “we have vaulted five years forward in consumer and business digital adoption in a matter of around eight weeks.”
Looking ahead, stock markets are likely to be supported by both structural and cyclical themes. On the structural side, the accelerated push towards digitalization and technology penetration are likely to underpin the performance of technology, consumer discretionary, and healthcare. On the cyclical side, there is scope for market broadening or rotation into the beaten-down cyclical stocks—think financials and energy companies—whose valuations are dirt cheap. These sectors are likely to benefit from the end of pandemic restrictions as vaccinations bring us back toward normal. It may be a very Happy New Year, indeed.