The unrelenting law of evolution

As the summer draws to a close, there is still much uncertainty about how the pandemic will play out, because we know little as yet about the virus behind it. What we do know is that people, businesses and governments have started adapting to that uncertainty, however belatedly. The attendant changes in behaviour will make it difficult for the global economy to make much progress after the third-quarter recovery. They will, however, limit the chances of a major new surge in Covid-19 cases – and are already producing stark contrasts in performance between sectors.

Managing crises is every bit as crucial for investors as making sure they don’t get the long-range implications wrong

In microeconomic terms, companies offering solutions to issues like mobility, health security and productivity are perfectly suited to this period. Their earnings have been rising since the beginning of the year. In contrast, other sectors are facing the stark choice between overhauling their business models or going under. The law of evolution can by no means eliminate crises, but it can hopefully provide a helpful reminder that such crises tend if not to trigger, then to mitigate or, on the contrary, accelerate long-term trends.

Managing crises is every bit as crucial for investors as making sure they don’t get the long-range implications wrong.

It is worth recalling that the epidemiological model produced early in the year by the highly respectable and esteemed Imperial College of London predicted that the coronavirus pandemic would cause as many as 2 million deaths in the United States and 500,000 in the United Kingdom. That model was apparently imperfect.

Whether under the influence of that grim outlook or because Western democracies felt it would be politically dangerous to go with a less drastic response to the outbreak than China, most of them opted for a large-scale lockdown, leading to the economic slump we experienced. Today, six months down the road, the world has resigned itself to trying to live with the virus. That means that, until an effective vaccine is discovered, tested, manufactured and distributed on a large scale, the threat will be with us. And it will affect behaviour, if only indirectly. As even widespread use of face masks won’t entirely eliminate the possibility of infection, the number of new cases recorded will increase as testing ramps up and young people become a bit more careless – though this is unlikely to bring about a serious spike in fatality rates.

Hotel, restaurant and transportation businesses will make it out of the inferno, but with a heavy limp, and the banking industry will need to cut costs to stay afloat. Conversely, the use of e-commerce, videoconferencing platforms – now universally acknowledged as effective corporate communication vehicles – and Web-based solutions will continue to gain ground, albeit with more gradual uptake rates.

During the first half of the year, financial markets were forced to adjust to an economic shock without precedent, followed by an equally unparalleled response from government. Effective risk management proved crucial to preventing disaster. But it is every bit as crucial at this stage to look beyond this distressed picture and figure out how far along the various adaptation strategies have made it, as this can tell us which species are endangered and which ones will emerge stronger than before from the crisis. As it seems that investors have basically figured this out, is there good reason to worry that they may have overplayed their hand?

Over the past decade at least, the fact that the whole job of treating the aftermath of the 2008 meltdown was left to monetary policy has produced a mediocre global economic recovery and a historic fall in interest rates. As a result, companies able to generate robust earnings growth despite that lacklustre backdrop have done enviably well in the stock market. Their share prices have been buoyed not only by a stronger bottom line relative to their peers, but also by a steadily decreasing discount rate for future earnings. The economic earthquake in the first half of 2020 has given an automatic boost to that trend, making the global macroeconomic outlook that much more uncertain and corroborating the view that interest rates will stay rock-bottom far into the future.

In today’s unwonted climate of acute concern over health security – a concern likely to endure – some corners of the tech industry have even increased their competitive edge, and the surge in average corporate debt levels has shown a spotlight on the financial health of Big Tech. Unlike during the dot-com bubble two decades ago, those big names boast extremely robust balance sheets and much higher profitability than other listed companies: average operating profit margins at US tech firms currently exceed 25%, versus under 10% for the wider S&P 500, excluding tech and financial stocks. This suggests that the striking outperformance achieved since the start of the year by growth stocks – located mainly but not solely in the tech sector – is justified.

This suggests that the striking outperformance achieved since the start of the year by growth stocks – located mainly but not solely in the tech sector – is justified.

Is that outperformance overblown? Not in our view. For example, the P/E ratio for companies in the MSCI World Information Technology Index currently offers a roughly 30% premium over the MSCI World Index. That’s barely above the historic average for the past 25 years (a 25% premium) and infinitely lower than the 120% premium at which tech stocks traded in 1999–2000. Or consider this other, very instructive point. The ratio of price to forecast long-term earnings growth is now about the same for the famous GAFAM stocks (between 2 and 2.5) as for the rest of the S&P 500 – which was far from true twenty years ago, when investors were willing to be pay much less for expected future growth at non-tech firms.

The current market’s fairly undiscriminating attitude towards valuation of growth stocks today is essential for two reasons. First, it shows that the tech sector is not overvalued once you take long-term growth potential into consideration. Second, this gives active fund managers an opportunity to offer major added value. In view of the present macroeconomic uncertainty, it’s hard to arrive at long-range estimates that deserve much confidence. Only in-depth knowledge and analysis of each company, its competitive environment, the disruptive technology affecting its business model and a slew of other factors can make that possible. The growing influence of passive management styles and the role played lately by online trading platforms for US retail investors in driving specific stocks to meteoric levels have created more and more valuation anomalies – and with them opportunities for an active investment approach that stands out from the crowd.

Given both the nature of the 2020 economic crisis and how it has been dealt with, it would be presumptuous to claim we can predict how it will pan out. After all, who knows whether the extraordinary government support provided to companies and consumers will be extended for long enough to prevent a sharp rise in bankruptcy rates (particularly at medium-sized enterprises), which could well throw the economy back into a slump in 2021? This question is relevant to both Europe and the United States, and adds to the mounting uncertainty surrounding the US presidential election in two months. On the other hand, we might see a breakthrough in the treatment or prevention of Covid-19, or a move by central banks to cross the Rubicon – by fully and avowedly monetising the unprecedented fiscal deficits building up – or at least part of today’s record household savings flow into the real economy. If all those boxes get ticked, if only temporarily, they could fuel the hope that we will ultimately emerge from ten years of macroeconomic lethargy and rock-bottom inflation expectations. This highlights the need to stand ready to act flexibly once again if necessary, because the law of evolution applies to everyone – starting with asset managers. In the meantime, the overriding imperative will be to construct equity portfolios composed, stock after stock, of names reflecting long-term convictions. For reasons of overall balance, those portfolios should also include assets with a connection to economic stimulus programmes such as corporate credit, as well as to their offshoots (e.g., fiscal deficits and an expanding money supply) like gold miners.

Source : Carmignac, Bloomberg, 31/08/2020