by Tony DeSpirito, Managing Director, Global Chief Investment Officer, Fundamental Equities, BlackRock
The economy and markets have emerged from the pandemic fundamentally changed. For equity investors, we believe this means a different opportunity set than the one that prevailed over the past decade and a half ― and one that favors alpha (excess return) over beta (market return).
Key takeaways
- The era of easy money is ended. The post-pandemic era is setting up to be more volatile with greater differentiation across individual stocks.
- Beta, or market return, is sufficient when a rising tide lifts all boats. In the more traditional investing landscape now forming, we see alpha at the center.
- A more discerning market that prices stocks on their underlying fundamentals is an opportunity for skilled stock pickers to outperform.
The pandemic period, inclusive of the crisis response and aftermath, roused an entirely new set of circumstances upon which the economy and markets are establishing their footing. For equity investors, we believe this regime change means a different opportunity set than the one that prevailed over the past decade and a half ― and one that favors alpha (excess return) over beta (market return).
“As the age of extreme moderation in inflation, rates and volatility ends, we see stock selection becoming more important as individual companies adapt to the new regime with varying degrees of dynamism and success.”
The end ― and beginning ― of an era
Capturing the essence of the new market regime requires context and reflection on the dynamics that existed prior to the current moment. The years following the 2008 Global Financial Crisis (GFC) were marked by 1) fragility and 2) unprecedented accommodation. Households and businesses were recovering from a deep recession and fallout from financial and corporate failures. For its part, the Federal Reserve (Fed) cut rates to near zero and implemented quantitative easing for the first time to stimulate the economy and help consumers and businesses heal, propping up markets in the process.
Fast forward to 2020 and the COVID-19 crisis. It was a time marked by a global economic shutdown and restart and an unprecedented combination of monetary and fiscal support that was far greater than that seen during the GFC even as the earlier crisis imposed a more potent shock to GDP. Consumer pockets were padded with stimulus money and demand for goods was great ― but supply was limited, having been disrupted by pandemic-related closures.
What followed was supply-side inflation ignited by the crisis, accommodated by fiscal and monetary stimulus, which was further exacerbated by war in Ukraine. Central banks vigilantly raised rates to combat soaring prices. While inflation is beginning to moderate, sticky elements such as wages are proving harder to bring down, setting the stage for higher inflation and interest rates for longer, just as stock valuations also are higher.
Investment implications: An alpha imperative
We believe the post-pandemic investment regime characterized by higher inflation, rates and valuations will require a new approach to equity investing. One implication of this new backdrop is lower market return, or beta, suggesting that a higher portion of equity portfolio returns will need to come from alpha, or excess return.
For the 12 years following the GFC, returns to beta were abnormally high as valuations moved from very low to normal, and the differentiation in returns between individual stocks was slim. Investors bought the dips and, as a result, the drawdowns were quite short and shallow. The Fed also was willing to come to the rescue in the case of any wobbles. Beta was king, as well-supported markets provided extreme performance, resulting in an average annual S&P 500 return of 15% over calendar years 2010 to 2021.
In contrast, the era before the GFC featured longer and deeper equity market drawdowns, as shown below, meaning more volatility as well as greater opportunity for skilled stock picking to deliver above-market returns (or alpha). We see this dynamic returning and the outlook for alpha turning more positive.
Five factors favoring stock picking
While there are no crystal balls in investing and markets are notoriously unpredictable, we see various market dynamics taking shape that support the case for an alpha-centric approach to equity investing:
- Equity market volatility that is more likely to increase than decrease
- Stock dispersion normalizing from narrow levels, separating winners from losers
- Stock specifics (vs. factors) having greater influence on return dispersion
- Currently narrow market breadth poised to widen
- Artificial intelligence driving opportunity and disruption
We dig into each of these in the full report.
The return of differentiated returns
In the regime now forming ― the post-pandemic era ― stock valuations, inflation and interest rates are all higher. Supply is being constrained by demographic trends (aging populations and fewer workers), decarbonization and deglobalization, all of which are inflationary as companies spend to adapt. Going forward, the Fed is more likely to be in a position of having to fight inflation rather than bolster the economy, a less friendly scenario for financial markets.
Equities historically have been the highest-returning asset class over the long term, and we see nothing to alter that precedent. However, higher stock valuations than at the start of the prior regime plus higher interest rates means less return from markets broadly (beta). We see more dispersion in earnings estimates, valuations and stock returns ― and this suggests greater opportunity for skilled active managers to generate more alpha. The result, in our view, is that the years ahead will see active return being a bigger part of investors’ overall return profiles.
