Preparing for a Post-COVID World
- Developed market equity valuations generally appear reasonable given
extremely low interest rates but vary widely among sectors and regions.
- The gap between growth and value stocks is almost without precedent, and
the rotation back to value—although difficult to time—is likely to be forceful.
- Likewise, the global economy’s reliance on unparalleled fiscal and monetary stimulus means tail risks have become elevated.
As of early August, the MSCI EAFE Index was trading around 18.5 times estimated earnings over the next 12 months—a modestly elevated level that can be justified in the context of very low interest rates. The market also seems to be rational in pricing in a further reopening of the global economy over the next 12 to 18 months. Even as we await a vaccine, treatment protocols for the coronavirus are improving, and a level of herd immunity seems likely to emerge. It also appears inevitable that people will allow themselves to engage in more risky behavior—for good or ill—as they grow fatigued with the shutdowns. Finally, valuations reasonably reflect the massive fiscal and monetary stimulus that has been directed at reviving the global economy.
Physical retail seems likely to be permanently impaired, and it is telling that e-commerce continues to grow in Europe even as shops reopen. Business travel will also bear lasting scars, but I expect it will come back to around 80% to 90% of its previous levels once the pandemic is over. People are social animals, and I expect that leisure travel and restaurants will eventually come back very strongly—especially as a wave of pent-up demand is released following the end of the pandemic. We should also see steady growth and progress in the health care sector, which is of course getting a lot of attention right now. We’re interested not only in pharmaceutical firms, but also in companies involved in medical services and diagnostics.
The performance gap early in the pandemic between growth and value in international markets was only matched briefly during the financial crisis, and the current differential remains extreme. It is very hard to identify a catalyst for value to rebound, however, partly because technical factors are at play. For example, Japan’s central bank is buying exchange-traded funds, which tends to favor stocks that have done relatively well and are heavily weighted in the indexes.
Rising interest rates and inflation could spark a market rotation, but that is not our base case; more likely, it is the continued reopening of the global economy that will eventually favor value. History does suggest that the reversal may be forceful when it comes—which is to say that there’s not going to be plenty of time to shift your portfolio. Accordingly, we think it’s important to consider having some exposure to value now.
Certainly, risk-free interest rates below zero in many regions make future earnings much more valuable. In that light, it’s understandable that investors are bidding up the stocks of companies with healthy and reliable cash flows, such as e-commerce and medical technology firms. What I find more interesting—and a source of opportunity—is that the market is not applying the same discount model to industrial companies, for example, that have more volatility in their cash flows but are still growing at a healthy pace over the long term. In theory, very low rates mean investors should also be favoring stocks with healthy dividend yields, but that is also not the case. This makes some sense, as dividend cuts have been occurring as companies seek to preserve liquidity. That’s why we’re less interested in stocks with a high dividend yield—often a sign of distress—than in companies that are able to grow their dividends.
The U.S. market is expensive relative to the rest of the world, which can be justified given its higher weighting in technology stocks and higher return on equity. But the valuation gap seems extreme, with stocks much pricier in the U.S. on sales and book value, in particular. Valuation differentials across sectors are still somewhat extreme—as, for example, with consumer staples versus financials. And, finally, there is the substantial gap between growth and value names within sectors. This is particularly true in health care, where we’re seeing opportunities in stocks that have been left behind in the momentum-driven rally.
Global Equity Valuations
(Fig. 1) Non-U.S. stocks are cheaper relative to history
For Illustrative purposes only and not indicative of any specific investment. Valuation and metrics are subject to change.
Median data points are for the trailing 15 years.
Sources: Standard & Poor’s, MSCI (see Additional Disclosures). T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.
The tensions with China are based on real issues surrounding technology and international competition, and you can make an argument that they might even increase under a Biden administration. We limit our direct exposure to China, partly because we are primarily focused on developed markets. We are also being careful to avoid companies involved in sensitive activities, such as technologies that enable surveillance.
At the same time, China is a huge market that offers real potential for investors, and we are invested in some leading internet companies as well as a couple of insurance firms. Recently, the prospect of Chinese companies being delisted from U.S. stock exchanges has gathered some attention, but that doesn’t really concern us. I expect they’ll just move instead to Hong Kong, which should not result in any substantial value destruction for investors. It’s also notable that emerging trade barriers with China are creating some opportunities for outside firms—as with European firms poised to seize 5G telecom equipment markets away from Chinese giant Huawei.
Investors do not seem to appreciate the global economy’s reliance on fiscal and monetary stimulus. Global central banks poured USD 4 trillion into the global financial system in March and have added more since. The U.S. alone is expected to run a deficit this year that is roughly equivalent to one-fifth of gross domestic product. While this extreme level of support may have been necessary, it’s clearly not sustainable. How and when the withdrawal of this underpinning will play out is highly uncertain, and history can offer a lot of different scenarios. But it’s clear that we’ve moved further out on the limb, so to speak.
Huawei was not held in the Overseas Stock Fund as of 6/30/20.
Source: MSCI. MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.
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The views contained herein are those of the authors as of August 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic development. These risks are generally greater for investments in emerging markets. The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. All charts and tables are shown for illustrative purposes only. Index performance is for illustrative purposes only and is not indicative of any specific investment. Investors cannot invest directly in an index. Actual outcomes may differ materially from any estimates or forward-looking statements.
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