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CPLIX’s Grant: Optimistic About ‘Remarkable’ Earnings Improvement, Resilient Economy—and Potential for Risk Assets

To Co-CIO Michael Grant, the only surprise is that the market has experienced so few episodic sell-offs since March. “Investors are acutely aware of political uncertainty, sensitive to virus developments, fearful of elevated volatility and the potential for leadership rotation,” the Senior Co-Portfolio Manager and Head of Long/Short Strategies said on Wednesday’s CIO call. Investment professionals, listen to a replay here.

But, he said, a “September chop should not be confused with a market top.” To the contrary, the CPLIX team expects the bull market in risk assets to extend into 2021.

“Equity recovery has been rational in the context of fundamentals, economic and corporate,” according to Grant. Going forward, the economy’s continued reopening and “some eventual” fiscal package will support demand while cost cuts will drive operating leverage. He describes these two as “a powerful combination to support earnings growth into 2021.”

“We are standing in 2021, we imagine the fruition of this record stimulus gaining traction across the major economies. We have witnessed the end of COVID and vaccines have proliferated. Is it that hard to imagine this as driving a much better economic backdrop than is currently embedded in risk asset prices?”

The market’s rally to date has been discriminate, with investors rewarding companies that have adapted most quickly to the economy’s challenges while overlooking opportunities with the potential to lead as the economic cycle evolves. While Grant concedes that some stocks are trading at excessive valuations, he considers many priced attractively given their medium and long-term potential.

“The global economy continues to heal, probably more than generally appreciated. Global short rates made new lows in August; the number of global easing announcements has been unprecedented. We all know that monetary policy typically works with a lag,” Grant said.

He anticipates a positive new year: “We are standing in 2021, we imagine the fruition of this record stimulus gaining traction across the major economies. We have witnessed the end of COVID and vaccines have proliferated. Is it that hard to imagine this as driving a much better economic backdrop than is currently embedded in risk asset prices?”

Grant framed his remarks in the context of “three nuances of the investment landscape” that have surfaced this year and he expects to be decisive for returns.

  • The dysfunctional politics of the virus
  • The “perfect storm” for duration
  • Growth versus value: “Someday this war’s gonna end”

The Virus

In July, Grant wrote that the pandemic in the U.S. was climaxing and would largely burn itself out by autumn. In fact, he said Wednesday, the outlook for COVID-19, treatments and vaccines is promising. U.S. hospitalizations and deaths peaked in April, while daily cases peaked in July.

CPLIX Positioning Timeline

Start of 2020

CPLIX net equity exposures were close to neutral at year-end 2019. Grant argued that clients were not adequately paid for late cycle equity risk as corporate earnings expectations for 2020 were declining.

March 2020

At the time of the outbreak of COVID-19, market valuations were already vulnerable, and the pandemic was an overwhelming catalyst that caused markets to plummet. The team believed it was time to lean into equities, increasing the net equity exposure to the net +50-60% range, where it has remained.

For Grant’s views at the time, see this March 23 post The Road Back to 3000. At the end of April, he predicted the market would recover by July (see this post).

June 2020

CPLIX recovered its first quarter drawdown by early June—half the time needed by the S&P 500 and most of its peers in the Morningstar Long/Short category. By June 15, the fund had recovered from the sell-off over the past three months, up 21.7% over the period. This improvement propelled the fund to up 3.49% YTD, eclipsing both the S&P 500 (-4.18%) and the Morningstar Long/Short Equity category average (-6.10%) for the same period. (And see this post.)

In June, the renewed spread of the virus throughout the southern and western U.S. was a surprise. While market behavior was bullish into the summer, there has been considerable style and sector rotation.

Looking Ahead

The CPLIX team expects a historically fast return to pre-COVID-19 levels of output, with global and developed market economies recovering to their prior peaks between the fourth quarter of this year and the third quarter of next. The U.S. economy will have returned to pre-COVID levels by late spring 2021.

Revenue growth for the S&P 500 declined 8% year over year in the second quarter, will likely beat the consensus expectation of down 4% in the second half of 2020, and will grow double digits in 2021. The bottom line: Grant expects the breadth of earnings improvement in coming quarters to be “remarkable.”

What matters now is no longer the virus itself but what Grant called the “politics of the virus.” He said, “Across much of the Western world, public debate is dominated by competition to demonstrate empathy and a precautionary bias…Governments are struggling to reconcile the pressure to appear precautionary with the need to restore economic life.”

Insufficient attention has been paid to the “multiple long-term costs of restricting social and economic activity,” according to Grant. “When the history of 2020 is written it will say that incomplete understanding led the developed world to adopt disproportionate and unsophisticated responses to a virus that, while capriciously contagious, is not especially fatal.”

The good news, he said, is that the virus crisis may have an end date: the morning after U.S. elections, November 4.

“Many view this election as more consequential than most. But the nuance is that the policy implications may not matter for equities until much later in 2021 or 2022. What may matter immediately is the end of the dysfunctional politics of the virus,” Grant said.

Assuming his analysis is correct, he looks for markets to begin to favor the “return to normal” parts of the market through October. Corporate fundamentals continue to matter, he said, expecting the October results season to be decisive for factor and sector rotation. “Watch the reaction of stocks closely as we progress through October.”

The Perfect Storm for Duration

To date, this year has been the “perfect storm” for duration and for long duration within the equity market. Quality, defensive, growth styles have been historic winners.

It’s the outcome of the swiftest economic downturn on record—driven, Grant said, “by a virus that removed all moral doubts that might have discouraged policy actions. The barometer of duration is interest rates. And interest rates are not just low, they are at the lowest levels in centuries.”

But Grant questioned whether long duration assets will ever again enjoy as favorable a setting as 2020.

“Now is normally the moment in the cycle—the classic recession to recovery stage of cycle—when valuations peak and begin a gradual compression as corporate profits recover.”

Instead, he said, the virus marks the start of a new regime: “the revitalized power of the Big State” and one that marks the end of a long disinflationary regime and “the beginning of the end for the supremacy of duration.”

“Democracies cannot tolerate prolonged deflation and thus, governments are finally responding with force: debt monetization, debt rescheduling and forgiveness. One doesn’t have to look far to see a perfect storm for reflation,” Grant said.

Grant identified a few implications for investment professionals. “Reflation, fiscal activism and more volatility of financial prices will bust up the portfolio construction strategies that worked so well in the past.”

  • Stocks that have been largely valuation winners should be avoided. The first “losers” of this shift will be utilities and REITs and many parts of the defensive consumer staple industries.
  • The 60/40 model. “The stunning success of this model is partly the outcome of the negative short term correlations between bonds and equities—but equally the consequence of the extraordinary fixed income gains over four decades. Those gains were ultimately the result of a political victory by those who control capital. Our industry has enjoyed 40 years of disinflation because of the shift in power in our economy from labor to capital.”

The end of duration is a high conviction view of Grant’s, as he said, “If I am wrong—if the 60/40 strategy works as well in the next decade as it has in the past, then democracy may have failed.”

Equity multiples are peaking now, Grant said. If the major benchmarks have further upside into 2021, it must be powered by earnings growth.

The CPLIX team is emphasizing stocks that they believe are poised for material earnings recovery in the coming year as part of the global recovery. This is a contrary bet to what has been working since early June, he noted.

Growth Versus Value

Because the recent outperformance of U.S. equities is attributable to a small group of tech leaders, the leading benchmarks are no longer the measure of “the stock market,” said Grant.

not all companies or sectors have rebounded at an equal pace

“Without their contribution it becomes clear that all developed equity markets have remained in a phase of consolidation since early June—neither participating in the July and August upside, nor the pullback in September,” he said.

Grant thinks that this is about to change or even is in the process of shifting now: “The nuance is that this may not be a debate between growth versus value, but recovery and normality on the one hand versus quarantine and COVID on the other hand.”

“Cyclicals rather than value are the real beneficiaries of negative interest rates,” said Grant.

Consumers are not happy with the decline in their quality of life since the pandemic. Grant and team expect considerable pent-up demand to drive renewed spending when normalization occurs. “The combination of negative interest rates and eventual normalization is a recipe for substantial style and sector rotation,” he said, adding that CPLIX is positioned accordingly.

Specifically, the CPLIX team is looking for 20%-30% upside in the composition of its long book, based on the expectation of broadening cyclical earnings recovery. Their preference is for cyclicals over defensives, less mega-cap exposure, and companies that can exhibit strong operating leverage to an ongoing recovery. The goal: to own stocks whose earnings per share over the coming year can rise more than the potential valuation compression in the major benchmarks.

Investment professionals, for more information about Grant’s perspective or CPLIX, contact your Calamos Investment Consultant at 888-571-2567 or caminfo@calamos.com.

Before investing carefully consider the fund’s investment objectives, risks, charges and expenses. Please see the prospectus and summary prospectus containing this and other information which can be obtained by calling 1-800-582-6959. Read it carefully before investing.

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