Diversify for the next leg up

The coronavirus crisis has hit cyclicals and smaller companies hard, as these economically sensitive businesses have suffered a significant drop in profitability.

• US mid-caps. Economic uncertainty has disproportionately weighed on the valuations outside of mega-caps and could recover further as more confidence returns. We continue to expect mid-cap earnings growth to outpace large-caps' over the next year, which should be a key driver of the mid-cap call. In the US, based on next year's earnings estimates, the Russell Mid-Cap index trades at a P/E that is about 5% lower than for the Russell 1000 index. This looks attractive relative to the 5% average valuation premium in the 10 years before the pandemic.
• EMU small- and mid-caps. In Europe, while small- and mid-caps have traded at an average 5% premium versus large caps over the last 15 years, they are currently trading at a 17% discount to large caps on a trailing price-to-book metric. The return on equity for EMU small- and mid-caps is currently 8.5% versus 9.2% for large-caps—a small gap that we believe does not justify such a large difference in their valuations. Other favored cyclical areas in Europe include Germany and “laggards with growth” that have underperformed the benchmark in the past year but could generate strong earnings growth in the coming year.
• ASEAN catch-up. While the economic recovery in Southeast Asia (ASEAN) is at least one quarter behind China’s, leading indicators like PMIs and accelerating money growth suggest a firm upturn lies ahead. They are also signaling the start of a new business cycle, which should lift industrial output and corporate earnings. After its near 20% underperformance versus the Asia ex-Japan region since late March, we see catch-up potential for ASEAN.
• Global consumer brands. With governments helping to maintain household income, people are using the money not spent on, for example, traveling for leisure, to buy more durable goods instead. This is great news for the manufacturers and retailers of those goods, but not so great for many other businesses linked to the “more normal.” We see global consumer brands across consumer discretionary, consumer staples, and healthcare as the main beneficiaries of an improving consumer environment.
• Reopening winners. The prospect of widely available COVID-19 vaccines should support economic growth globally in 2021. Following restrictions on travel, both for leisure and business, we now see pent-up demand being unleashed. We expect this to help companies in Europe, Asia, and the US as economies reopen.
  

Low inflation expectations and extremely low bond yields have underpinned the outperformance of growth over value in recent years. These trends accelerated this year amid falling interest rates and growth expectations, as well as a simultaneous supply-demand shocks that have rocked global energy markets. If economic growth accelerates more quickly than currently expected by the market, and if the near-term disinflationary impact of lockdown measures recedes, the downward pressure on yields and energy prices should ease, which in turn should support a recovery in value versus growth. But we do not see a full reversion to the mean, which would likely need rising bond yields as a precondition, so we think a selective approach is required at this stage.

• UK stocks. While earnings will contract in 2020, the worst is likely behind us, favoring a significant earnings rebound in 2021, in our view. This revival will be driven by the global economic recovery that is already underway, and by the comeback that we expect to see in the oil price. We also think a Brexit deal is more likely than not. The UK market is one of the cheapest developed markets in our universe, and it is trading at a 30% discount to the MSCI AC World index, compared with a 10-year average of 10%. 
• Emerging market value stocks. We think that after a decade of underperformance, value should catch up amid a cyclical recovery in emerging markets. Value also offers attractive dividend yields in a low-rate world and is less exposed to concentration risk. Based on past episodes of value catch-up in 2016 and 2018, we think value has the potential to outperform the MSCI EM Index by 10–15% in the next 6–12 months in up and down markets.