Covid-19 created significant volatility and disparate returns in equity markets across the globe through 2020. In 2021, Australian private investors will likely need to rotate their traditional Australian stock portfolios into different geographies, sectors, and underlying factors to maximise the income and capital return opportunities on offer. Dynamically managing these factor risks are likely to remain a high priority in a world where prospective risk and correlations of investments can change rapidly.
Usually, the dislocation caused by severe shocks to the global economy gives nimble investors ample opportunities to invest in assets at deep discounts to their intrinsic value. While there were undoubtedly opportunities in 2020 in listed equity markets through March and April, the bounce back was swift, and many investors failed to take full advantage.
Now as global growth is bouncing back strongly and corporate earnings are returning to pre-pandemic levels, further equity market gains are likely to be more gradual. Price earnings multiples are elevated compared to history, but other metrics should give investors some comfort than equities offer some better value. The earnings yield of equity markets still compares favourably to the yield in bond markets and the earnings multiples will naturally moderate as strong corporate earnings growth comes through over the next few years.
But not all markets offer the same risk return trade off.
While the Australian market has responded strongly to be near the highs reached a year ago, returns have been driven at an aggregate level by a concentrated list of companies in a small set of industries. There is undoubtedly a larger opportunity set in global markets to rotate portfolios into different regions, sectors, and other underlying risk factors to add further investment performance.
The US is exposed to greater set of digital winners, technology stocks and other secular growth stories and probably deserves a premium relative to the rest of the world due to above-average secular growth and quality. Eurozone equities valuations are attractive as they tend to outperform when global purchasing manager indexes are rising however corporate earnings are lagging global peers in Japan and the United Kingdom.
While the outlook for many emerging markets in our region remains challenging as they rely heavily on tourism and old economy industries, the prospects in China looks more promising. Growth should rebound strongly in China, and their equity market is now dominated by new economy stocks which should benefit from the government focus on environment, technology, and digital health in the latest 5-year plan.
Sector rotation will be an important driver of value add in 2021. Investors should be rotating out of sectors that have performed well during lockdowns and pivot to sectors that have lagged. Consumer staple stocks benefited strongly over the last year but generate only moderate earnings growth while valuations remain demanding. This sector continues to be exposed to intense competitive pressure from niche brands and other disruptive forces.
While property securities, particularly office and retail stocks, performed poorly during Covid-19, their outlook remains somewhat mixed. The positive impacts of economies reopening will continue to fight against the structural headwinds of working from home and online shopping. However, the prospects for infrastructure appear more optimistic. There are attractive opportunities within infrastructure sectors globally to deliver capital growth and a 5 per cent dividend yield. Sectors such as transportation, telecommunications, and renewable energy will attract significant capital after years of underinvestment.
Healthcare offers exposure to defensive and good quality companies and benefit from various secular growth themes including digital health, demographic trends, and structural growth in emerging markets. Financials, particularly in offshore markets, continue to be attractively valued across the board and positive economic momentum and some further modest increases in bond yields should provide a solid environment for returns. Dividend growth and share buy-back programmes will add further impetus to returns.
Relative to the market, information technology trades at a slight premium due to attractive growth perspectives and above-average balance sheet quality and miners have historically outperformed when global purchasing managers' indices are rising and price to book valuations are trading at an attractive discount to historical averages. The global economic backdrop should see capacity utilisation rise to pre pandemic levels and should be supportive for industrials with investment-led growth, rising capital expenditure and increasing capital-goods orders. In addition to the cyclical backdrop, we see positive secular trends in industrial software and robotics.
Value as an underlying risk factor has rallied more recently as it outperforms the market when global purchasing managers' indices are rising, and the yield curve steepens. However, after the initial bounce back in growth has occurred, the long run structural trends should re-establish and support quality over value. Quality stocks continue to offer structural growth opportunities and first-class balance sheets that are attractive investment criteria in a low interest rate and growth world. Valuations of quality stocks are demanding but there is little catalyst for a re-rating on the horizon.
Smaller companies should outperform larger stocks over the next year. In the US, large capitalisation stocks are expensive relative to the smaller end of the market and in Europe larger stocks tend to be more defensive and underperform when growth picks up. In a low yielding world, high-dividend stocks should be well supported, and European dividend stocks appear more attractive due to better valuations and balance-sheet quality.
What is clear that not all sectors of the global equity markets have the same outlook and intelligent diversification is about understanding the underlying factors and correlations that drive investment returns and being prepared to take active portfolio decisions to capture the most favourable opportunities.