Market report July-August 2020
Decided to start the summer season report with a closer look at the technology stocks sector, about which also wrote in July. The rise in tech stocks appears to be unstoppable. Giants like Apple and Microsoft, as well as tech-driven consumer companies like Amazon and Alibaba Group, are also doing well during the COVID-19 pandemic. In the meantime, an emerging group of vibrant, innovative leaders, from cloud service providers to e-commerce enablers, are also showing solid growth, fueled by the rapid business and consumer change caused by the pandemic.
The Nasdaq Composite Index rose by 20.5% this year to July 31, while the MSCI World Technology Index rose by 20.8% over the period. Compared to the more subdued increases in the S&P 500 and MSCI World indices, it is perhaps obvious to all that investors are prioritizing technology stocks when constructing investment portfolios. Profits boosted the valuation of technology companies. Global technology stocks are traded at a price/earnings ratio valued at 26.5, a 30% premium over the MSCI World Index. In these unprecedented times, some high prices are justified, especially for businesses that have drivers for sustainable growth. Investors should revise a few myths in order to be able to find investment opportunities.
Myth 1: More about valuation, then the fundamentals
Is a tech company valuation appropriate and is there too much emphasis on price and too little on earnings growth potential? It is possible.
Let’s look at the stock prices of the first generation iPhone and Apple in 2007. Apple shares traded at a staggering price of around $ 18, based on a sales forecast of 3 million units worldwide in the first year. Compare that to the 200 million units of sale every year today. So is Amazon, which has always been considered expensive. But even with a revenue ratio of $ 280 billion at the end of 2019, the company consistently beats analysts’ revenue expectations while turning its break-even point. Innovative technology companies can look expensive when viewed solely on the basis of estimation consensus at a static moment. But real technology leaders have vision and persistence. They are constantly improving and reinventing to maintain a competitive advantage thanks to new products and services, adapted to the changing and growing market needs. Sometimes success requires a willingness to change their business models today to secure a future – perhaps one of the most difficult and controversial things to do. Netﬂix when it first surprised the market by radically giving up its DVD-by-mail rental service, which was quite popular at the time, and introduced an unproven streaming model that now boasts 193 million subscribers. Amazon is also a classic example here. What started as a traditional online bookstore has grown into a technology powerhouse that includes retail, advertising, streaming media, logistics, and cloud infrastructure services. Over the course of this journey, current estimates estimated the company’s growth potential and stability, often misreading individual risks or returns.
Myth 2: All tech companies are overpriced
Technology is not a homogeneous sector, and not all tech companies are overpriced. In fact, the sector’s valuation premium is relatively low compared to its historically high level. At the peak of the market in March 2000, MSCI World’s communications technology and services sectors collectively accounted for 35% of market capitalization and less than 18% of profits. But today these two sectors represent 30% of market capitalization, but almost 25% of all profits. In an increasingly connected world, technology companies are increasingly enjoying the positive benefits of the network effect, allowing them to leverage scale and generate higher incremental margins.
Myth 3: High valuation = high risk
Is paying more for stocks more risky? Not necessarily, especially when the reasons and perceptions behind high valuations can be so different. For example, technology companies with sustained and long-term growth factors are seen as having greater predictable profit growth compared to cyclical companies that are more dependent on the macroeconomic forces affected by the pandemic and are therefore considered much more risky.
In the current profit season on the market, IT companies are among the few that report an increase in revenues and profits on a year-to-year basis. Technology companies also fared much better than expected. About 74% of IT companies in MSCI World reported higher revenue expectations and 78% reported positive surprises, compared to only 51% and 56% for the overall market, respectively. In our view, higher valuations reflect the low risk tolerance of a broad investor base. Today, tech companies are valued similarly to consumer staples, while offering better growth characteristics. For example, the share of traditional retailers and technology companies that provide IT services and equipment on-site may appear cheap, but could face further declines if the pandemic continues and adversity worsens.
The low interest rate environment is also fueling the prospects for technology development. Fast-growing companies tend to have larger revenue streams from future revenues and profits. Thus, when rates remain low, income streams benefit from lower discount rates, driving up the present value of the share price.
A successful innovative company is more than a good idea. Sustainable innovators should offer sustainable income and profit growth potential. At present, sufficient market liquidity is looking for very few opportunities for growth, many of which belong to smaller, lesser-known companies. Not all companies are just another Amazon, but some may have the qualities to become the leaders of the next generation, offering products and services with breakthrough impact and relentless, innovative DNA that continually reinvents their paths. While some may seem expensive based on short-term estimates, ultimately the most important task for investors in technological innovation is to identify the next breakthrough leaders who can deliver sustained and unexpected growth after a short boom period.
Calm before the storm, i.e. about the expected upward wave of corporate insolvency
Expect most of the business insolvencies are yet to come, mainly between the end of 2020 and the first half of 2021, as a result of unequal initial conditions as well as different re-opening strategies and emergency policy measures, in particular regarding the moment of bankruptcy. The global insolvency rate is likely to reach a record high of + 35% by 2021, cumulated over a two-year period, with half of the countries posting a new record since the 2009 financial crisis. The United States will see the biggest increases (+ 57% by 2021 compared to by 2019), Brazil (+ 45%), China (+ 40%) and major European countries such as the UK (+ 43%), Spain (+ 41%), Italy (+ 27%), Belgium ( + 26%) and France (+ 25%). A premature withdrawal of policy support measures could aggravate the situation, increasing the number of insolvencies. Should the global economy take longer than expected to recover from the Covid-19 shock, the spike in defaults could increase by leaps and bounds. However, while further business support will limit insolvency in the short term, it may also support zombie companies, increasing the risk of more insolvencies in the medium to long term.
The long-term outlook suggests a solid foundation and is most likely already discounted in prices
There are still significant risks. The potential for a second wave of the virus and possible further economic blockages is present, especially as fall and winter are just around the corner in many parts of the world. Geopolitical threats include the November US elections and ongoing US-China trade tensions. However, an enormous global effort to innovate in the race for a vaccine and effective anti-virus therapy could eventually pave the way forward. Adaptation to COVID-19 is accelerating the pace of digitization, which is likely to disproportionately benefit scalable business models using small amounts of capital and positively impact corporate profits. The discounted valuations of potential winners nowhere come close to the levels we saw during the tech bubble. Unlike the loss leaders in 2000, these firms have substantial cash flow and large market share. The powerful stimulus from the central bank should keep yields under control for a while, giving the world economy time to recover. This environment should be especially friendly to growth companies: their cash flow is distant into the future, so their valuations should benefit from persistently low interest rates. Positive economic surprises, as well as the improvement in frequent expenditure and transaction data, suggest a gradual recovery in the global economy.
Will low volatility stocks (treated as derivatives to bonds) return to favor?
Given central bank accommodation and low inflation, government bonds are likely to continue to be effective at diversifying risky assets, and exposure to other fixed income sectors will provide additional income. Given the low level of profitability, investors using multiple assets should explore a wide range of measures to increase income. One source is stocks that are sold as bond substitutes, such as low volatility stocks that typically have stable cash flow and high dividend yields. These stocks were deeply discounted as the pandemic strained cash flow and investors began to worry about dividend stability. When that happened, the historically positive correlation between these stocks and US Treasury bonds decoupled.
Chart: Low volatility stock prices become more attractive
Historical analysis does not guarantee future results. As of July 31, 2020
Low volatility stock represented by a sample of Invesco S&P 500 Low Volatility, iSharesEdge MSCI Min Vol USA, iShares EdgeMSCI Min Vol Global. Rolling 3-year correlation calculated using weekly relative returns (S&P 500 for US ETFs, MSCI ACWI for Global ETFs) of the ETF sample and the Bloomberg Barclays treasury index (unsecured).
Source: Bloomberg and AllianceBernstein
Brexit in the era of the Covid-19 virus
Reaching a mutually beneficial Brexit agreement has so far been unattainable for the negotiators of the United Kingdom and the European Union (EU). COVID-19 has made the world a very different world from when we last wrote about Brexit. We argued that the UK was likely to exit its interim deal with the EU later this year under World Trade Organization (WTO) terms or under a simple trade deal – an outcome that was once called hard Brexit. We thought this would increase the likelihood of a recession in the UK, leaving the pound vulnerable to all sorts of risks. After a few months, the likelihood of a negative Brexit result increased. Negotiations on future trade relations between the UK and the EU have produced little progress and the deadline for renewing the UK-EU interim agreement has passed. While negotiations appear to be taking place in a more cordial manner, there is little evidence that an agreement has been reached on the most contentious points: equal conditions for all, fishing rights and the role of the European Court of Justice. In addition, the EU remains concerned about the implementation of the Northern Ireland Protocol to avoid a hard border on the island of Ireland (without which there will be no agreement).
We are entering a more intense period of direct negotiations. The UK would like to close matters by the end of summer so that it can continue preparations for the end of the transition phase – including a return to WTO conditions if necessary. But if the negotiations are not fully concluded, the summer time limit seems optimistic. It is quite possible that the discussions will drag on to October, a difficult deadline for the EU if it wants to ratify the agreement before the end of the year. We have identified four scenarios for the end of the transition phase: no/WTO agreement, limited agreement, strict alignment and enlargement:
+ Limited deal: zero-rate system on goods, but nothing else (i.e. no service contract and UK leaves the EU Customs Union). In 2015, it could be called a hard Brexit. This would be more destructive than no deal, but could still have a significant negative impact on growth;
+ No Deal/WTO: No Deal – UK-EU trade relationship is not compatible with WTO terms. It would be very tedious;
+ Close alignment: UK and EU agree on a comprehensive trade agreement that keeps the UK in close regulatory harmony with the EU and minimizes economic disruption. It would be beneficial for growth;
+ Extension: The transition period can be extended for a maximum of two years once, but only if agreed until July 1st.
In my assessment of the situation, the first two scenarios are the most likely. The balance of risk is weighed towards one of the more destructive scenarios – no contract or limited contract. This is because any deal that keeps the UK in close regulatory harmony with the EU would require one of two unlikely events: either the UK government would have to renounce its commitment to voters or the EU would have to jeopardize the integrity of the single market. It may still be possible to extend the transition phase and the UK government has shown no interest in pursuing this option. The key point, however, is that any of these scenarios would disrupt the UK’s trade relationship with the EU without a service arrangement and the reintroduction of customs and regulatory controls on goods.
Global stock markets
Pound sterling (GBP), local currency (Loc.) And relative currency (Rel.) As at 08/25/2020.
Source: RCieSolution Research
Visit social profiles:
The views expressed in this document are not research, investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.