Preparing portfolios for the post-health crisis world

Jérôme van der Bruggen - Chief Investment Officer

While it is still too early to make a definitive assessment of the long-term impact of the health crisis on our economies, one thing is clear. States have played a substantial role in its management and have, on this occasion, regained a prominent place in the conduct of business. It seems that on this occasion we have moved away once and for all from the laissez-faire approach that has characterised the last forty years.

To keep businesses and households going while the pandemic raged, governments put in place huge support packages, financed entirely by debt. This rescue was made possible by the activity of the central banks, which intervened as lenders of last resort by buying these loans on the secondary market, thus becoming the primary government creditors.

Many called for this cooperation between governments and central banks even before the health crisis. The state of emergency caused by the pandemic made this cooperation a necessity. But at a time of deconfinement and with restrictive measures being lifted, the question arises of the sustainability of state interventions. Won’t governments just take advantage of the recovery to reduce their debts?

A post-crisis period marked by US plans

Probably not, judging by the tone of US post-crisis management. Mr. Biden’s administration has prepared three plans for a total of USD 6 trillion, indicating that it has no intention of withdrawing and returning to the old model.

After having succeeded, in March 2021, in passing a support plan allowing economic support programs to continue while the vaccine strategy took hold (the “American Rescue Plan”), Mr. Biden unveiled a second plan (the “American Jobs Plan”) in the same month. This plan, which could be voted on as early as October 2021, aims to boost investment in order to renew the infrastructure and – among other things – to facilitate the energy and digital transition.

He then proposed a third plan (the “American Families Plan”) in April 2021, the aim of which is to breathe new life into the US-style welfare state project initiated by Barack Obama. This third plan could be voted on next year.

What these latter two plans of Mr. Biden have in common that they will be partly financed by taxes: on companies for the second plan, on the highest incomes for the third plan. But in the background, no one doubts that the Fed will provide support if needed.

Markets driven by the recovery in earnings

The equity markets reacted well to these developments and continued the recovery that began in March 2020. All of them are now above their historical highs (including Japan). In our view, this equity market recovery may continue as it is supported by a real recovery in earnings. Driven primarily by strong household spending (which is supported by governments and where savings were accumulated during the pandemic), corporate earnings are rebounding after the lockdown shock in 2020. Last year, companies’ earnings in the global equity market indices fell by an average of 20%. This year, earnings growth could exceed +35%.

An important element that makes us think that this earnings recovery is not over is that investments have not yet really taken over. In a typical business cycle, investment, i.e. business spending, follows household spending. In other words, companies only start investing again when they are confident and encouraged by signs of recovery in household spending. It is worth noting that in the United States business investment did not reach satisfactory levels during the last period of economic growth which lasted until 2016. With the Fed having put the brakes on growth by raising its key rates, this confidence has not really had a chance to bounce back. This time, the Fed has promised to wait longer and the American Jobs Plan – if it is passed in the autumn – will give companies an extra incentive to invest.

However, there are two potential obstacles to this recovery.

The first is raising taxes in the US and in particular raising the corporate tax rate to 28% and stopping profit transfer practices – if these plans pass Congress. Isn’t this likely to be detrimental to profits in 2022? Yes, but beyond this initial observation, it should be borne in mind that this tax increase will be offset by increases in earnings linked to investment spending by US companies. In other words, the total negative impact on earnings will be smaller and US earnings are expected to rise again in 2022.

The second is the increase in the price of raw materials and the shortage of parts in certain production lines, which is leading to increased production costs. Isn’t there a risk of this having an impact on margins? The answer is complex, and not all sectors are affected in equal measure by this inflation. However, we observe in the short term that as long as demand is strong, companies are able to increase their selling prices (as we have seen in the results of the automotive sector in Q1 2021). In the medium term, higher prices encourage producers to increase their supply through new investment projects, allowing a return to balance. The current higher prices are not, in our view, a permanent phenomenon.

At a time of deconfinement and with restrictive measures being lifted, the question arises of the sustainability of state interventions.

A pro-recovery position on the equity market

The expected returns on equities are still higher than the yield on risk-free bonds, indicating that equities still offer an attractive yield premium over bonds. Of course, this premium can be largely explained by the downward pressure exerted on long-term bond yields by the central banks. But there is also the fact that earnings expectations are constantly being revised upwards at the moment and during a period of investment recovery, it is difficult to foresee the end of this trend. So we believe that the equity markets should continue to be favourable, although one should always be vigilant and ensure that investments are diversified.

Mr. Biden’s infrastructure plan will benefit local US companies and companies in the commodities, industrial and financial sectors. These companies, smaller than the GAFAMs, have been left behind in the equity market rally of the last 5 years and are trading at a discount to technology and pharmaceutical stocks. We are therefore focusing on them in our portfolios at the moment.

Corporate tax reforms in the US – if passed – are another reason to favour these companies over the big tech and pharma stocks. These reforms are less likely to hurt companies in the commodities, industrial products and financial services sectors. One of the reasons for this difference in treatment is that tax transfer practices are most prevalent in the high-tech and pharmaceutical sectors, in short, sectors that traditionally pay less corporate tax. If this is the case, it could have the effect of fuelling sector rotation towards these cyclical, real-economy, small-cap companies. Does this mean that GAFAM share prices will collapse? No, for the simple reason that the digitalisation trends in our societies are far too strong. But the underperformance of this sector cannot be ruled out.

In summary, growth stocks remain attractive in the long term but we tactically favour a pro-recovery positioning, mainly via small-cap and/or cyclical stocks.

¹ The expected “return” of a listed stock is calculated by dividing its expected annualised net earnings (per listed stock) in one year by its share price.

² A “risk-free” bond is a 10-year bond issued by a benchmark authority, in this case the US Treasury, the German government or the Japanese government.

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