Equity Markets vs. Main Street: Views on the Divergence and Considerations for Different Sectors

Equity Markets vs. Main Street: Views on the Divergence and Considerations for Different Sectors

May 13, 2020

Lee Rosenthal/Host: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.

Ahead on this episode: why is there such a divergence from Main Street to equity markets, and, are markets ahead of themselves? Plus, key investment considerations for different sectors and types of companies in the post-pandemic world. Stephen Dover, Head of Equities with Franklin Templeton speaks with Katie Klingensmith, Katie take it away.


Katie Klingensmith: Welcome, Stephen. Equity markets were experiencing tremendous ups and downs, including the largest daily drop for US markets since 1987. Since then, we've seen more muted volatility and markets have rebounded. Do you think that the impact of COVID-19 has really fully been priced into equity markets or is there a divergence right now that worries you between what looks like an emerging economic reality that is potentially quite dim and stock markets that have recovered quite a bit of their losses?

Stephen Dover: The biggest question that I've been asked, certainly since March, the recovery of the stock market is what is this huge divergence between Main Street and Wall Street? And, I'm not an economist, I'm actually a stock market strategist, and I say that because I think that we often listen to a lot of economists and sometimes we forget that the stock market is not the economy. And while they are a reflection of each other somewhat, there can be quite a divergence. And having quite a bit of experience around the world, probably the greatest example of that over the last 20 or 30 years would be the massive growth of China. And while the Chinese market has done well recently, its stock market did not reflect its growth in its economy.

Back to your question, Katie, what's this divergence between Main Street and Wall Street? Well, in February when the market plummeted, it was because of complete uncertainty and all risk models were thrown out the window. And remember, the famous opinion article in the Wall Street Journal and other places said that upwards of 2 million Americans might die from this virus. Since that time, I think there's four things that have affected the stock market.

Of course, first of all, is monetary authorities around the world lowering rates. In the US to zero, but in other countries below zero and that dropped the bond yields. That was because of the second reason and there was a massive tie up in liquidity. The Fed’s liquidity response allowed the debt markets to loosen up. But, the Fed has basically instructed investors to go out and take on more risk.

The third thing of course is the massive fiscal stimulus, which is more spending in just a month than we normally spend in an entire year, very focused primarily on smaller businesses. And so, all of that helped the market to have liquidity and to come back.

Now, that partly explains the fall in the market and the recovery. The volatility in the market, I think, is primarily explained by all of us watching on a day-to-day basis the coronavirus new cases, rate of change, and how long it's going to be before the economy recovers. This is where I think the news is really wagging the market. When we look on days of news about a vaccine, you can understand why the company producing the vaccine would have a big change in price, but it's kind of hard to understand why the market, in and of itself, would have such a big change. So, there's still a lot of speculation in the market.

Katie Klingensmith: Given all that, there's a lot of discussion around U-shaped versus V-shaped recoveries or just discussions around how long it will take to see the US and the global economy start to pick back up. What's your view?

Stephen Dover: Yes, I would say that my letter would be a “W,” or a wave return of the economy, seems to me to be pretty clear that we will not have a V-shape, that there won't be a day that we all go back and everything recovers. But it also seems that this is a shock and as people go back to the economy. Fortunately, it was in very strong health when we went into this and is likely to recover.

The reason I say a W-recovery or a wave recovery is I think that some areas will probably recover pretty rapidly or actually are doing better in this situation—of course, the technology companies come to mind—and some, the extreme case of course being something like cruise lines or theaters or travel may take a very long time to recover. So I don't think it's going to be a uniform recovery, I think it's going to be very wavy and as investors we're going to have to look at that.

The issue is all of this stimulus that the monetary authorities are doing and the government is doing, is that stimulus going to get back into the real economy and have it grow? In terms of valuation of stocks, one of the reasons stocks are so high is the presumption that this is just a blip, it hurts earnings this year, perhaps into next year, but then everything goes back to normal and that's the presumption that justifies the current stock prices.

Katie Klingensmith: Given that certain sectors or certain behaviors are so affected by the health concerns. How do you think the US policy response might affect consumer behavior and growth going forward?

Stephen Dover: Consumption in the United States is huge, it’s 70% of the economy. And so, the big question that we need to focus on is, is the consumer going to come back? In simple terms, the consumer, and not to catch up, if you will, in the services economy, which is primarily what we have in the United States, but there probably could be some catch up in delayed buying of things that are manufactured. Obviously, one of the biggest events being cars.

I think that what's likely to happen in the United States is that the portion of the economy that is driven by investment is likely to increase as supply chains and the way that we manufacture and the way we look at our country is restructured. I think that's probably one of the big changes that's going to come out of this. Comparing this to other countries, consumption is a higher portion of the economy in the United States than it is in other countries, particularly emerging markets countries. So how countries and economies and companies are affected as is really going to vary by country and by industry.

Katie Klingensmith: I think we want to spend a little bit of time, and I know this is your background, too, on how emerging market economies and companies will do given the public health concerns there and the drop in tourism and the drop in global demand.

Stephen Dover: So, I'll give a broader answer and then I'll give the specific answer. And you know, the other question I get is what's going to happen to globalization and is it going to change? And my blunt answer to that is absolutely. It already was changing, and this is a catalyst to how globalization will change.

I think that, first of all, in general, when people are in crisis, they look to their nations or their local governments in times of stress and so there's probably going to be a bit of an increase in nationalism and looking at our local governments. There is going to be probably a very big difference in how supply chains are managed going from just in time [JIT] to perhaps just in case [JIC]. So, there has to be a margin of error there that we didn't have before.

Strategic items, which we didn't use to think of a strategic, such as health care is likely to come back to nations and the United States. I personally expect an increase in industrialization, I referred to that before, versus consumption. In some sort of way, I would be very bullish on the Midwest of the United States. I think there's going to be a lot of growth there.

Specifically, looking at your question around emerging markets, of course that's dominated by China. I've been a relative bull on China for a while. China's had the best performance of any market this year. And China's share as part of the emerging markets index has risen to over a third of the total index. And all of Chinese companies are not included in that index. And if they were, China would be close to 40 or 45% of the emerging markets index. So, when you talk about emerging markets, you really have to talk about China plus other markets. China is starting to get out of the strict COVID-19 lockdown. It's getting closer to normal, hotels there are about 70% occupied. We'll see if there's the second wave or not. But China's economy will change, as well. China will have to be much more consumption-oriented country and less export dependent.

And, I think one change in globalization is perhaps in the past we didn't have real globalization, we had China being the big producer and the United States being the big consumer and that's likely to change. The United States and other developed countries are likely to diversify their supply chains particularly to other emerging markets. So, that's positive for countries that are, say in the Southeast Asia or Mexico where things can be supplied to the developed markets.

So, we’re relatively positive on China. We're looking positively on countries in Southeast Asia and we are cautiously watching Brazil and Indonesia. Brazil has been particularly hard hit by the COVID virus—a lot of potential there, investment opportunities, it's been a strong market, but we are concerned about the effects of the virus there.

In general, within the emerging markets we're focusing on the consumer growth, technology. I think it's really important to know that emerging markets are very, very different than they have been in the past. They’re much less dependent on commodities and on exports than they were in the past and they have a higher portion of technology than most of the other benchmarks around the world, so we see a lot of opportunity on the technology side in emerging markets.

Katie Klingensmith: It sounds like it's very important to understand the dynamics in individual countries. I think it's probably also important to be very specific about how we invest from a style and sector perspective about the future of value investing.

Stephen Dover: I think that probably, we as an industry have gotten ourselves into a little bit of trouble making the world as simple as growth versus value. And particularly, looking at value based on price-to-earnings ratio or price-to-book, which is how the index works. Most of us, who've been in this market for a long time have been convinced that value outperforms over a very long time. There's a lot of academic research that indicated that that was true, but it hasn't been true certainly for the last 10 years.

When we're talking about growth, it's really highly concentrated. There are five companies that account for something like 20% of the growth that we have in the market, which is highly concentrated and it's a few companies. And it isn't growth in the same sense that we've traditionally thought of it as relatively levered companies that have high growth, but just don't produce a lot of cash flow. The FAANG [Facebook, Amazon, Apple, Netflix, and Google] companies are very profitable, they spin off a lot of cash and they have a lot of growth. So, it isn't traditional growth.

The other area that has had a lot of market appreciation has been what I would call quality companies or companies that have persistent earnings. When you're in an economy that has basically zero interest rates, that search for yield doesn't just happen within the bond market, it also happens within the equity market and it makes a lot of sense to pay a lot for a company that has it a steady and growing earnings stream. And that's why those companies have done so well.

And what that has done, is it's made the value companies, the energy companies or the commodity companies or in many cases, the financials which haven't done very well. So I think the future of value isn't to invest in a value index, but it's rather to try to look at forward earnings and forward PEs and forward price-to-book and buy those companies that are undervalued based on a forward projection, which none of the a value benchmarks are able to do. So, there's a lot of opportunity in value, the first quarter of this year had the greatest spread between growth and value that we've ever seen it’s gargantuan. But that said, the variety of portfolio managers think that growth relative to value is overpriced and that there's going to be some coming together between those two strategies.

Katie Klingensmith: The energy sector has been the worst performer year to date. What are your expectations for oil prices and the energy sector going forward?

Stephen Dover: I think there's a few issues and the first issue is that, obviously, there's a huge demand to fall in oil and I think that's probably the issue that everybody looks at. But, Saudi Arabia and Russia were in a war with each other to try to influence the oil market. And they were trying to undercut the American market, but they did it at exactly the wrong time. It couldn't have been worse timing. But, these countries that produce oil, I think it's important to note that they have the need for higher oil prices. So if you look at a country like Saudi Arabia, it's cost to produce a barrel of oil, we don't exactly know, but we think it's somewhere, I'd say between $2 and $8 a barrel. But Saudi Arabia is spending so much to try to rebuild its country, it actually needs oil at $80 a barrel to cover its fiscal deficit. Russia itself needs oil at $45 a barrel to fit its fiscal needs, Iran needs oil at $70 a barrel. My overall long-term view on oil is that it is very unlikely to recover anytime soon to the prices that it had before.

Katie Klingensmith: And just one more question on sectors. Are there particular sectors that you're watching that you expect will lead us out of this downturn?

Stephen Dover: So certainly, we are very much watching technologies that can help to keep supply chains cost effective, while making them more reliable by bringing things back home or at least closer to home are almost sure to be post-pandemic winners. We're all working at home or buying things at home. While we might pull that back as we go back into the streets, certainly the larger technology companies are sure to benefit. I don't have any argument with that. Whether they're priced correctly, that's different issue. Here would be my concern about, specific stocks. The first thing is the capital structure of companies.

So let’s harken a little bit back to 2008 and the banks. I mean, there was a lot of concern about the banks’ earnings and about the banks’ balance sheets. Well, with help from the governments, the banks actually ended up having earnings that were fine, but their capital structures changed and they were diluted. And that's one of the main reasons banks have not performed over the last 10 years. I'm concerned about these companies that have taken on debt that they will have earnings dilution and so, not be able to have the earnings needed or not be able to cover their debt, or at least not to provide earnings for the shareholders.

I'm concerned about companies that had very significant stock buyback programs. Stock buyback programs, I think, are going to be cut pretty dramatically. One, because companies that take money from the government can’t have stock buybacks. Secondly, just because companies need to get cash, so they're just less likely to do buybacks. And three, politically, there is now a big political movement to stop buy backs. This is not a small issue. Buyback's accounted for about 30% of the volume of the stock market back in 2019. So, big cut back in buybacks is a big issue.

And of course, when I talk about changes in the supply chain, the reason the supply chain went to China was to save money. And so, companies are going to have increased costs as that supply chain moves back to the United States. So some will benefit from that and some won't, but that's not necessarily a sector call. It's really having to look at the individual companies and how their situation is going to change.

Katie Klingensmith: Sure. And it certainly underscores the importance of bottom up research. Can you walk us through a couple of the different scenarios that you could see unfolding over the next year?

Stephen Dover: Yes. So, the optimistic scenario and the scenario that justifies the current stock prices is by the first or second quarter of 2021, we're back to where we were in the first quarter of this year. So that's the V-shaped recovery, which seems to be what the, what the stock market is pricing in. That would probably require massive testing, and perhaps a vaccine, and the economy, as a whole, getting pretty much back to normal with a large amount of stimulus coming back. So that's one scenario. That's good for the market in general. Obviously, there are some areas—cruise lines, hotels—that will probably not recover.

The other scenario, is that these companies actually have a lot of debt that they're going to have to pay back. Buybacks aren't going to happen as much as people think. And so, we would have, at a minimum, a correction and perhaps going back to the new lows. When I survey our portfolio managers, most of them think that the market is ahead of itself, I think that's kind of a sign that we should be cautious.

I'm very bullish in the stock market for the long term. So I don't have any question about where you should be in the 401(k) and retirement plans, but if someone's making shorter term decisions, the stock market where it is now, I'd be quite hesitant. I think the second issue is really debt management. The reserve banks around the world are, in essence, telling us to be risk on and to have more debt. But, I think managing debt, certainly reducing any debt to lower-cost debt, but for those that have steady earning streams, it might make sense to have some debt and invest that for the long-term.

Katie Klingensmith: Thank you so much for those comments and for this conversation today, Stephen.

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