The last quarter of 2020 was extremely positive for equity markets, driven by several announcements from vaccine trials. These suggested not only that a vaccine was possible, but that they would be far more effective than even the most optimistic of expectations. The accelerated approval of these led to the rollout of vaccines beginning in December, an incredible feat given that the virus was little known 12 months ago. The rally in equities reflects the expectation that the reopening of economies will begin far earlier than and more fully than previously anticipated. However, this change in outlook did not impact all shares and sectors equally, with the biggest rises being achieved by those hardest hit so far this year. This has led to one of the sharpest rotations into “value” stocks seen for a long time.
Some of this optimism was tempered by increasingly severe outbreaks in the US and Europe, and a more infectious strain discovered in the UK, causing more stringent measures to be implemented in the shorter term. However, markets have been far more willing to look through these short-term issues, provided companies have the means to survive through them. The most significant risk from this point is that the vaccine rollout programme meets a serious issue, such as logistical problems or currently unknown side effects. The take-up of the vaccine may also not be widespread enough to reach population immunity. Furthermore, while it is now anticipated that the developed world will manage to vaccinate sufficient at-risk citizens in 2021, it may take much longer for the bulk of the world population to have access to one given the current issues around cost and transportation.
The other major events of the quarter were political. The US presidential election saw a narrow win by Biden, which was forecast prior as the worst outcome for markets. Nevertheless, equities rallied at the result, apparently through relief that the event was now in the past. However, legal challenges and right-wing attempts at falsely debating and questioning the result continues. It is therefore difficult to foresee when this will be fully concluded.
Elsewhere, the Brexit saga reached a conclusion, ending in a deal that appears broadly satisfactory to both sides, which should lift the heavy cloud that has been hanging over the UK economy and investments. At such an extreme discount, a change in external investment flows into UK markets could lead to a period of outperformance for UK equities, breaking a multi-year streak of underperformance. The reaction to the deal in sterling has been more modest than predicted, however, we would expect that there could be a moderate rerating over the coming months as money returns, bringing global positioning back to a more neutral level.
Overall, the rollout of an effective vaccine we see as a game-changing event, at both a market level and importantly the underlying market leadership. Nevertheless, there are clearly short-term problems and the risk that mutations add to the immediate risk.
Equity Valuations
As discussed previously, it is likely that traditional valuation metrics such as P/E ratios are not going to be as effective measures in the current environment. The earnings component has taken a significant hit this year, and there is the potential for losses in many companies and sectors. This is going to make PE ratios look high as investors are rightfully looking at 2021 expected earnings.
There have been further upward revisions in earnings both for 2021, but also for 2020. The latest analyst estimates are up 6.2% higher for this year and 2.3% higher for 2021, justifying some of the rise in share prices. Furthermore, given that these estimates are yet to fully include the effects of a vaccine rollout, there is clearly scope for the 2021 figure to be revised up further as we move through next year.
While there is positivity around earnings, this has been reflected in share prices, which continue to trade at high multiples by historical standards. However, while the market has risen, earnings expectations kept pace, leading to no further multiple expansion.
As discussed previously we have not looked to over-interpret index level price-to-book data, as it is increasingly difficult to analyse, particularly for tech-heavy markets such as the US. However, comparisons of recent price-to-book values may be another tool to assess the “cheapness” of markets. Book values should be more stable than earnings through this crisis, and in theory should provide a better indication of the long-term value of companies. Nevertheless, there is a high chance that some companies (e.g. the Energy sector) will be compelled to write down book values in the current environment. Price-to-book values have continued to increase.
Overall, it is difficult to argue that the market is cheap, however, there is a greater than usual uncertainty in the outlook for earnings and as we do believe that there is scope for earnings revisions higher, the P/E multiple is easier to digest for next year. The valuation of equities also needs to be considered in light of the very low level of bond yields (both government and credit), as well as the continuing central bank and government support. With large amounts of money searching for returns, the equity market may continue to find buyers at higher prices, as long as there are not significant negative changes to the current pathway out of the pandemic.
