Peter Spijkman, senior investment specialist, outlines his outlook for equities in Aegon Asset Management’s 2021 Long Term Outlook.
Are there opportunities amid pricey markets?
Momentum may have moderated in the last few months, but stock markets are still showing strong returns for the year to date. They have been pushed higher by supportive monetary and fiscal policies worldwide, but lofty valuations now have investors worried.
It is easy to see why: from a historical perspective and on most metrics, shares look expensive. Interest rates are low, along with spreads on many fixed income asset classes. The difference between the earnings yield and the interest rate on government bonds gives an indication of how investors are compensated for taking equity risk and this measure is at historically low levels.
However, while aggregate valuations look high, the real picture is more nuanced with very high valuations in certain regions and for certain sectors. US equities in particular are currently relatively expensive, particularly compared to the UK and Europe. This difference in valuation is largely explained by the sector composition of the markets and the dominant industries. The US has a greater weight to the highly valued tech sector, while Europe has a higher weight in lower valued
sectors (notably financials, energy, materials and utilities).
Supportive earnings growth
The high valuation of the tech sector is not irrational but is backed by strong growth in the sector at a time when low interest rates make growth particularly valuable. Corporate profits in the tech sector have grown almost twice as fast as those of the wider index. There is every reason to believe this growth can continue: there has been a trend towards greater use and adoption of technology, which has been accelerated by the pandemic. This helps justify the sector’s higher valuation.
More broadly, higher valuations for equities are supported by expected earnings growth. In 2020, there was a severe decline in reported profits due to the impact of Covid-19 on the global economy. In the course of 2021, it became clear that economies worldwide would recover quickly and corporate profits would follow suit. For 2021, we expect profits to grow about 30% compared to 2019.
Certainly, there are a number of risks for stocks. An increase in corporate taxes, for example, would reverse the recent trend for countries to compete to offer companies lower tax rates to stimulate job creation, both at the companies themselves and within the supply chain. Governments can no longer afford this largesse. The world’s 20 largest economies have signed a plan for global reform with a minimum tax rate for multinationals, limiting the scope of multinationals to shift profits to tax-friendly countries. This could knock corporate profits, particularly in areas targeted by policymakers, such as technology.
What does this mean in practice?
For developed markets, we expect a return of just under 6% annually in US dollar terms for the coming years. The dividend yield is likely to be lower than in recent years due to higher valuations. We expect a dividend yield of approximately 1.6%. An important component of long-term equity returns is profit growth. For the coming years, we expect corporate profits to rise further and as a result dividend growth will likely be higher than inflation. We are assuming around 3% real dividend growth. As earnings recover, we expect equity multiples to decline slightly. Equally, we expect equity valuations to remain above historical average as low yields on fixed income assets will keep valuations elevated.
Within developed markets, we are more positive about the US than Europe in spite of higher valuations. We prefer to lean in to structural shifts such as digitization and automation. Technology companies are also expected to grow faster than the more traditional sectors over the long-term. Small caps may also prove a fertile area, showing higher earnings per share growth compared to large caps. There are real opportunities, even though aggregate valuations look high.
Click here to view Aegon Asset Management’s 2021 Long Term Outlook