Financial markets remain torn between near-term concerns about the evolution of the COVID-19 pandemic — infection and hospitalisation rates are rising in the US after the Thanksgiving holiday and tighter restrictions are anticipated; Europe may well see a third wave in the new year as lockdowns are eased over the holidays — and medium-term optimism about the deployment of coronavirus vaccines.
Financial markets are pricing reflation
US 10-year Treasury yields initially rose by 25bp after the first vaccine announcement and nearly touched 1% before dropping back 15bp. Revived expectations for a large fiscal stimulus package from the US Congress have since prompted a renewed sell-off in yields. The S&P 500 and Nasdaq indices meanwhile have reached all-time highs.
Falling November eurozone PMIs showed the inevitable impact on business sentiment of the re-imposition of (albeit partial) lockdowns. In the US, the PMIs surprised positively, however, as states and cities have yet to react meaningfully to the deteriorating pandemic figures (though December may show more pessimistic attitudes).
Consumer demand, even in Europe, is so far holding up well as government programmes support incomes. Retail sales growth in Germany jumped to 8.2% year-on-year and held steady at 8.5% year-on-year in the US, although these figures are only for sales during October.
Vaccine hopes boost value stocks
The key dynamic for markets remains the rebound in value stocks since the announcement of the first, better-than-expected results for a coronavirus vaccine early in November. Value stocks have subsequently outperformed growth stocks by 7% percentage-points in the US and by 12% in Europe (as of 1 December 2020).
The biggest sector contribution to the strong value index performance came from financials, particularly in Europe (see Exhibit 1). This is partly because financials have a bigger weight in the European index than they do in the US (26% in Europe, 19% in the US), but also because financial stocks have rallied more in Europe, by 23% vs. 15%.
Exhibit 1: Contributions by sector to index returns
Data as at 1 December 2020. Europe is MSCI Europe Standard index, US is Russell 3000. Sources: FactSet, BNP Paribas Asset Management.
A key driver of the financials sector’s returns has been the increase in interest rates discussed above. Yields across Europe have risen, too, though generally not by as much as in the US. Banks have also been boosted by the prospect of the economic recovery arriving sooner than expected, reducing the amount of loans that are likely to default as businesses face extended shutdowns.
Second to the financials sector in Europe comes energy, which has mirrored the 26% rise in Brent oil prices in November. Again, the contribution of the sector to value’s performance is larger in Europe than in the US due to its larger weight in the index (it is twice as large in Europe). The sector in second place for contribution to the value index’s return in the US is industrials, thanks in part to gains in airline stocks.
Though not illustrated, the sectors that have lagged among growth stocks are exactly those which benefited the most during the lockdowns: internet retail, technology, and home entertainment.
What can maintain the momentum?
Whether or not value’s outperformance continues will depend on the medium-term prospects of each of these sectors. We do anticipate interest rates rising modestly over the course of next year, which should support financials. If interest rates rise too far, however, the central banks are likely to step in via QE purchases (particularly in Europe), so the upside potential is limited.
As travel resumes and commuting patterns are re-established, demand for oil should rise. Even after the rally in Brent this month, let alone from April’s low of USD 19/barrel, the current price is still 30% below the level at the beginning of the year. Other transportation-related companies in the industrial sector should also see sustained gains.
On the growth side of the equation, stocks leveraged to the internet (technology, web commerce, streaming services) are likely to lag now following the significant run up in valuations during the lockdowns. The premium of growth stocks to value stocks has fallen with the rotation over the last few weeks, but it is still more than 30% higher than the long-run average in both the US and Europe. Some of this additional premium has been generated since the onset of the pandemic as the desire for earnings growth amid the recession became ever more acute.
The prospect of modestly higher interest rates and oil prices on the one hand and, on the other, marginally less demand for internet-leveraged companies plus relatively high valuations, suggest to us that the rotation we have seen into value should continue.