Equity markets staged a strong comeback after the coronavirus-induced sell-off crashed the stock market earlier in the 2020 financial year. Stock market valuations appear to be expensive now, after the recent sharp rebound happened, despite earnings deterioration in the last couple of quarters. But this paints an incomplete picture of opportunities, as the ultra-low interest rate environment presents equities as a relative bargain and can be an attractive option considering the outlook for economic recovery, supportive monetary policy and subsequent earnings recovery in the 2021 financial year.
The primary equity market mirrored the secondary market to deliver surprisingly robust growth in IPOs to overcome a significant slowdown in the first half of 2020 (H1 2020) due to the pandemic. The recent rally in the stock markets also supported newly listed stocks in delivering strong returns to investors.
Review of 2020
This year started with improving optimism over global growth, US–China trade progress and an accommodative monetary backdrop that buoyed risk appetite, propelling US and world equities to record highs at the beginning. However, the outbreak of the novel coronavirus changed the course of equity capital markets, as the pandemic unfolded economic and financial miseries across the world.
A lot of businesses across many sectors have been forced to reduce operations or shut down to control the pandemic and protect human lives. The crisis entails an increase in fiscal deficits of various economies due to unprecedented trade disruptions, slump in tourism, sharp contraction of manufacturing activities, prolonged commodity price declines, massive unemployment and soaring levels of public debts. The world witnessed the shortest and sharpest recession wherein global GDP fell by 10% in H1 2020.
The coronavirus pandemic’s onslaught on risky assets (conventional and Shariah) pushed stock markets to a new low, abruptly ending one of the longest bull runs in the history of equities. Most of the stock markets entered a bearish phase after recording sharp declines owing to the economic fallout from the pandemic and the resultant pressure on corporate earnings.
However, equity markets recovered strongly and now trade slightly below from the 2020 financial year high, due to rejuvenated market sentiments following signals of virus containment, gradual reopening of business activities and expectations of corporate earnings recovery.
The Islamic equity markets continued to outperform their conventional counterparts across all major regions (see Chart 2) despite challenging market conditions. The outperformance trend was mainly driven by technology stocks which tend to be overweight in Islamic indices and which were the best performer among sectors on the back of significant earnings growth. On the other hand, financials were nearly absent in Islamic indices and continued to trail behind the broader market which also contributed positively to the outperformance.
The global market for IPOs is poised to deliver a bumper 2020 financial year, although the activity was placed in a deep freeze during the second quarter of the year when companies put plans for new listings on ice at the height of the coronavirus pandemic. After an initial hiatus of physical roadshows that were hampered by social distancing, bankers have adjusted to a new way of working, ie with virtual roadshows and investor meetings, etc. A total of US$195 billion has already been raised during the year (as of the 30th September 2020) and the number could go higher with a strong list in the pipeline for the rest of the year. In fact, the year witnessed one of the world’s biggest IPOs (Ant Group raising US$34.4 billion). The primary market was mainly driven by large and prominent transactions in the technology, industrial and healthcare sectors, accounting for 62% by deal numbers and 67% by proceeds.
Preview of 2021
The global markets are still in the early recovery phase of the cycle following the coronavirus pandemic recession. This phase is broadly characterized by a period of low interest rates, lower inflation growth and stimulus packages which provide an environment for the 2021 financial year where equities are likely to be favored over money market instruments and other fixed income securities.
Interestingly, a divergence between economic wellbeing and stock market valuations is causing anxiety among global investors that there may be a bubble on the horizon in the 2021 financial year, particularly for stocks in certain sectors that have performed exceptionally well in the recent recovery rally.
This phenomenon of an underlying economic contraction (or slower recovery) and advancing stock market indices will be hard to sustain in the long run. At any sign of trouble, investors may look to lock in profits during the course of 2021. However, such a correction will consolidate markets to gather steam for further upside.
Ongoing concerns regarding the evolution of the coronavirus pandemic and the impact of further lockdowns, global trade tensions (US–China–EU) along with the outcome of US elections remain the key headwinds going into 2021. The governments and policymakers are expected to continue their monetary and fiscal support to mitigate these challenges.
Nevertheless, the economic data is steadily recovering and the market is ‘looking through’ this year’s dreadful recession to a meaningful recovery in economic growth and corporate earnings (expected to deliver about 35% growth on a year-on-year basis) next year. This will set the stage to support a positive stock market performance in 2021.
The positive momentum of the secondary equity market coupled with the high amount of liquidity and relatively low volatility point to a fertile ground to raise capital in the coming year. Entrepreneurs are likely to capitalize on the positive trend to strengthen balance sheets or fund acquisitions and growth.
Looking ahead, new technology, healthcare and industrial companies that can demonstrate resilience, adaptation to the current environment and sustain profitability will have an opportunistic advantage and will be popular investor choices to park their investments. The companies in sectors hard-hit by the pandemic may have to sit on the sidelines before a new window of opportunity opens for them.
The primary market is likely to witness a continuation of reforms next year which will also create a favorable environment for investors, primarily by way of regulatory changes and enforcement in order to attract companies to get listed on their exchanges.
Heading into 2021, a spate of both unusual uncertainties (coronavirus pandemic) and usual uncertainties (Brexit, US presidential election outcome, US–China–EU trade tensions) may create a level of unpredictability and potential volatility. However, there is a strong pipeline of companies (SpaceX, Didi, ThredUp, Grofers, Databricks, Instacart, Rubrik, Illumio, Outreach, Ginkgo Bioworks, Digital Ocean, TransferWise, Zomato, etc.) looking to take advantage of the IPO transaction window in the coming year and the silver lining for IPO buyers is that volatile periods are often likely to provide some of the greatest investment opportunities because even fundamentally strong companies will need to price attractively.
The equities are a compelling investment choice in the 2021 financial year for many reasons despite being touted as ‘expensive’ right now. A 10-year treasury yield below 0.75% (unlike the 1990s where the treasury yield was above 5%) means a business has better odds of generating the cash flow needed to exceed the treasury rate. The dividend which has historically provided a sizeable slice of the total returns pie across all markets has currently ranged between 1.8% and 4.1%. Unless the 10-year treasury yield approaches 2–3%, a scenario that could be years away with central banks committed to providing the economic support needed to emerge from the coronavirus crisis, investors should prepare for ‘high’ equity multiples. Further, the stock market seems to have incorporated earnings growth in the coming year considering economic recovery with the reopening of businesses, ease of traveling restrictions, normalization of supply chains and continuation of government stimuli. Investors will favor those stocks that are embracing emerging technologies or capitalizing on new trends and are expected to reap the fruits of their proactive business modification efforts in the coming years.
Robust IPO activity in 2020, despite the challenges, suggests that companies are choosing to protect their value through capital markets in the coming year. Entrepreneurs are seizing opportunities to go public to shore up their capital base for future investments and remain resilient against a potential new wave of the pandemic or any other uncertainty. The strong valuations seen in some of the recently listed ‘new economy’ companies and those not impacted by the pandemic are giving positive signals to other potential IPO candidates that are looking to complete their transactions in the coming year while investors are optimistically looking forward to seizing investment opportunities, a win–win situation for both corporates and investors.
The views and opinions expressed in this article are those of the author’s independent personal opinion and should not be construed to represent any institution with whom the author is affiliated. You should not treat any opinion expressed here as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of an opinion.