Prepare for potholes on the road to recovery
In comparison to 2020, which was a year of economic contraction, 2021 is shaping up to be a year of moderate economic recovery.
While new strains of COVID-19 are emerging and populations globally face restrictions on their daily lives, there is a light at the end of the tunnel as countries around the world are starting the gargantuan task of inoculating hundreds of millions of people in the coming months.
However, in AXA IM’s view, while this is a very positive step there are reasons for investors to remain cautious. Last year, despite the initial shock to equity markets in March, most indices recovered and rallied hard into the end of the year. This was despite substantial falls in earnings that were triggered by the coronavirus pandemic, meaning that on naive valuation measures many markets ended the year looking very expensive.
In addition, there may be potential impediments to the rollout of vaccines, causing further volatility in global markets and rapid shifts in investor sentiment, as witnessed in November 2020 when those stocks most sensitive to Covid-19 rallied the most on the positive vaccine news.
As a result, our view is that investors should consider positioning their portfolios to capture potential market upside and future earnings growth, while maintaining a clear focus on mitigating downside risks.
Managing risks in equity portfolios
AXA IM’s Sustainable Equity strategy is designed to be a cost-effective, lower risk core allocation for equity portfolios.
The strategy aims to build and protect clients’ wealth sustainably, historically outperforming when markets fall and participating when markets rise.
It invests in a broad range of geographies, sectors and companies, focusing on identifying those that display low volatility and high earnings quality. The strategy also uses machine learned tail risk filters to avoid stocks at risk of distress and valuation screens, so stocks with inflated or extreme valuations are weeded out.
This active management approach means the strategy has the potential to avoid many of the risks associated with index investing – exposure to bubbles and avoidance of low risk and poor-quality companies, for example.
However, as with any active approach there are times when market events may go against the strategy, and 2020 was an environment that tested some aspects of our approach to diversification and how we measure risk.
The rise of mega-cap technology names as the winners from Covid-19 – with the FAANG1 stocks (Facebook, Apple, Amazon, Netflix and Google) growing to almost a quarter of the S&P500 Index – was extraordinary, and these largest index names became the lowest beta stocks in the first half of 2020. Their success is understandable but drove rapid research into more dynamic ways to model volatility and control diversification, ensuring that the strategy is better able to withstand similar situations in the future.
In addition to actively targeting companies with low volatility and high quality, the Sustainable Equity strategy also incorporates environmental, social and governance (ESG) analysis.
The integration of ESG is used to enhance traditional financial analysis by identifying potential risks and opportunities beyond technical valuations, providing data on issues such as reputational risk and identifying companies that are leading the way on ESG issues.
One of the goals of the Sustainable Equity strategy is to achieve a low carbon footprint and a better ESG score than the index. Thematically, this is likely to be important as we enter the new Biden presidency, which has a revolutionary climate agenda.
A long-term perspective
The extreme market events of 2020 provided a real acid test for AXA IM’s Sustainable Equity strategy, which was resilient when markets initially fell but underperformed the risk-on recovery in markets, particularly the vaccine euphoria of November.
Despite this, since inception the strategy has delivered on its objective of outperforming its benchmark with lower total risk and improved ESG characteristics. The average downside capture is 78% while typically capturing 85% of subsequent recoveries from market falls.
The strength of the recent recovery, driven as it was by supportive fiscal and monetary policy and in the absence of earnings growth, is likely to be short-lived, and 2021 should see some moderation from the bust and boom of 2020.
Source: AXA IM, MSCI, as of Dec 2020. Data based on net of fee return of the AXA IM Sustainable Equity Fund in A$. Past performance is not a guide to future performance. It is not possible to invest directly in an index.
Looking forward, we see 2021 as a year of recovery for markets, albeit with some potential potholes in the road ahead. While there is optimism around a COVID-19 vaccine, the potential for new strains and lockdowns is likely to temper investor sentiment. However, we think the strategy is well positioned for 2021 for the following reasons:
- Improved market breadth: As we move through 2021 and into 2022, the role of stimulus should shift from recession mitigation to growth generation across a broad range of economic segments. Such an environment should improve equity market breadth, supporting a wider group of stocks and investment styles than in 2020, where returns were dominated by a narrow band of mega-cap growth stocks.
- An active approach to quality: We expect the recent weakness for high-quality investments to be shortlived once the initial vaccine euphoria fades. We believe the crisis has acted as an accelerant to existing structural trends; quality and quality-growth stocks should continue to benefit from this, as well as from a continued low interest rate environment. However, the fact that quality remains relatively expensive argues for an active approach, such as that implemented by Sustainable Equity.
- Sustainability: The Covid-19 crisis, in our view, will strengthen trends that were already in place and should accelerate the transition to more sustainable economies. By avoiding ESG laggards and focusing on the leaders, Sustainable Equity remains well positioned to benefit from this trend.
The road to recovery from the current crisis is unlikely to be smooth, so for investors who wish to capture the upside potential of markets while also managing risks to the downside, our Sustainable Equity strategy may be a potential way to meet the challenges of the months ahead.
 Companies mentioned are for illustrative purposes only, and not to be considered as investment advice or recommendation.
Risk factors with this strategy:
Company specific risk: There may be instances where a company will fall in price (or rise in price) because of company specific factors (for example, where a company’s major product is subject to a product recall).
Highly volatile markets: The prices of financial instruments in which the strategy may be invested can be highly volatile.
Market risk: Changes in legal and economic policy, political events, technology failure, economic cycles, investor sentiment and social climate can all directly or indirectly create an environment that may influence (negatively or positively) the value of your investment in the strategy. In addition, a downward move in the general level of the financial markets can have a negative influence on the strategy.
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