Darren A. Jaroch, CFA
Portfolio Manager of Putnam Equity Income
Fund and Putnam International Value Fund
Lauren B. DeMore, CFA
Assistant Portfolio Manager of Putnam
Equity Income Fund and Putnam International
Darren: While 2020 brought us many unpredictable events, we still had some familiar trends. For example, investors once again started asking, "Is it time for value stocks to take the lead?" It almost made 2020 feel like any other year. We began to see a rotation into value stocks late in the year. Value started outperforming growth in September, and in November, the Russell 1000 Value Index delivered its highest-ever monthly return, handily outperforming its Russell 1000 Growth Index counterpart.
The rotation took a dramatic turn on a single day — November 9 — when Pfizer announced impressive efficacy results for its COVID-19 vaccine trials. On that day, the S&P 500 Index's value stocks outperformed its growth stocks by the biggest margin in records going back to 1993, according to Dow Jones Market Data.
Value stocks tend to take the lead coming out of a recession. However, the 2020 recession — no surprise — was different from any we've seen. In April, when the equity market began to rebound after its steep sell-off, momentum growth stocks outperformed dramatically and continued to do so throughout the summer while value stocks lagged. The gap between the most expensive and least expensive stocks was stretched to some of its highest-ever levels. Now, as we look at this latest rally in value stocks, we are being asked whether it is durable. For a number of reasons, we believe it is.
Lauren: To understand why we believe the value rally has long-term potential, it helps to look at the value stock surge in November. News of an effective COVID-19 vaccine had a profound effect on investor sentiment. Suddenly, the idea of leaving our homes for shopping, dining, travel, and entertainment felt like a distinct possibility. While the pandemic has been a financial hardship for many, there are also many households that built up significant savings in 2020. As we enter 2021, we see considerable demand for leisure spending as well as more assets in savings accounts that are ready to be deployed.
Among the biggest headwinds for value stocks in 2020 were sharp declines in inflation expectations, interest rates, and bond yields. We expect a reversal of this in 2021. Inflation is likely to pick up as spending and demand resumes — both from consumers and from businesses that had held back on capital expenditures due to the pandemic.
The case for financials
The financials sector, which was the epicenter of earnings uncertainty in 2020, is now fertile ground for a rally, in our view. This is the case for bank stocks especially, which underperformed the S&P 500 by about 35% in 2020. Going into 2021, banks should be able to outperform based on technical drivers alone — the potential for inflation and higher interest rates. Throughout 2020, historically low rates put pressure on net interest margins — the difference between interest earned and interest paid on loans and deposits. Also, banks took an unprecedented level of reserves against their loan books in anticipation of loans that could go bad over the next couple of years. In 2021, we'll get visibility on the adequacy of those reserves, which will provide a floor for earnings expectations. We believe this visibility will give investors more confidence in the return profiles of banks. Also, from a higher-level sentiment perspective, the broader market has been trading at all-time highs and looking past the damage of COVID-19 for broad segments of the economy. At some point, this optimistic view will need to extend to banks, especially as investors recognize how inexpensive these stocks are.
Darren: Key ingredients for a prolonged value rally are some inflation and modestly higher interest rates. While the 10-year Treasury yield is still a long way from where it was at the start of March 2020, a look at some non-U.S. markets provides perspective. China, for example, has largely returned to a more normal growth trajectory, and has seen interest rates return to their pre-pandemic levels. We believe this is a preview of what we're likely to see in developed markets that are currently still grappling with the pandemic.
As for inflation, few investors are expecting it since it has been so low for so long. However, it's important to note the Federal Reserve's recent decision to employ "average inflation targeting." The fact that inflation has been so much lower than the 2% Fed target means the Fed will almost certainly allow inflation to run hotter for some time.
Lauren: Earnings trends are also key. In 2020, uncertainty about earnings potential and significant write-downs for companies across the value universe contributed to the underperformance of value stocks. In 2021, we believe the earnings backdrop will be much more favorable, and we don't expect meaningful downgrades to earnings expectations. Assuming the distribution of COVID-19 vaccines goes well and the pandemic's damage to the economy is not greater than expected, we have a solid setup for value stocks in 2021.
Darren: There will be debate over whether multiple waves of the COVID-19 pandemic will result in more permanent economic damage. So far, the market has looked fully past that, anticipating a return to normal in the second half or final quarter of 2021. We have the prospect of herd immunity, pent-up demand from consumers who are eager to go out and spend their savings, and the potential for more fiscal stimulus for those who are struggling. We also have the clarity that came with the U.S. election results, which indicate that massive legislative changes are unlikely. Over the past 10 years, we've seen many head fakes in the value market leadership story. Does the 2020 value rally have legs? We believe the prospects are good.
Our view on airlines
Few industries have more leverage to a return to normal than travel. There is a pent-up demand for "experiences," and vacation planning is likely to be a priority for many consumers. We added to our position in Southwest Airlines a few times during 2020. Reasons for our conviction include:
- Balance sheet is its savior. Coming into the COVID-19 pandemic, Southwest was the strongest airline from a balance sheet perspective. The stock never underperformed as dramatically as network carriers like Delta Air Lines and United Airlines.
- Ready to go on the offensive. The network carriers all took federal government help and tapped all of their credit lines. While they work to de-lever their balance sheets, Southwest should be able to gain market share. Network carriers will need to eliminate routes and optimize their networks for a much different environment.
- Less exposure to business travel. While we can't have family vacations via Zoom, we can continue to conduct most business meetings without traveling. Southwest focuses on leisure travel, which we believe will recover much more quickly.
- Better for tentative consumers. Southwest is a low-cost U.S. carrier, which will be beneficial if U.S. consumers remain tentative about spending or traveling internationally in a post-COVID world.
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