Slowing growth and rising inflation is a negative combination for both equity and bond markets. Nevertheless, there are opportunities emerging for global equity investors.
This has been a challenging year for equities. Russia’s invasion of Ukraine has led to soaring energy and commodity prices, a global stock market slump and elevated volatility. Recession appears likely, certainly in Europe and probably in the US too. There is also an increasing risk of a prolonged period of “stagflation”, when real economic growth remains absent whilst prices continue rising.
Whether the ultimate outcome is recession or stagflation, the implications for corporate earnings are clearly negative. Margins are likely to experience pressure over the coming months as cost pressures become apparent and top-line revenue growth begins to slow. In this environment our focus is on pricing power. Looking further out long-term drivers of growth, such as climate change, are being over-looked. There are many opportunities for those with patience.
The Tech-heavy Nasdaq index already entered a “bear market” (a 20% decline from the most recent peak) in May. The S&P500 and the Stoxx600 Europe both passed through that milestone in early June in US$ terms. After a multi-year period of under-performance, the UK equity market has held up relatively well with a fall of 12% (including dividends). The heavy weighting of energy and commodity companies in the UK index have supported the FTSE, as has the exposure to large pharmaceutical companies such as AstraZeneca and GlaxoSmithKline.
History shows that the average duration of a bear market is 290 days. Over the past 140 years, markets fall by 37% on average in these periods, which suggests potential further falls on both sides of the Atlantic with the floor of the S&P 500 perhaps at the 3,250 level. As always in bear markets, continued elevated volatility is to be expected, with significant rallies likely at certain time, depending on news flow, as well as material drawdowns. This is likely to be particularly pronounced around Q2 earnings reports, which typically begin in mid-July in the US.
Whilst the stand-out sector YTD has, not surprisingly, been energy, every other major global sector has produced negative returns. Pandemic beneficiaries in the technology and consumer-facing sectors, which had huge incremental revenue and profit gains during the lockdown period, have been particularly heavily hit. Rising prices for electricity, heating, gasoline and food have forced consumers to rein in their spending, particularly for the more discretionary or expensive items not essential to daily life.
It is notable that a number of retailers in the US such as Walmart, Target and even Amazon, have all experienced a significant moderation in revenue growth as well as a rapid build up in inventory of unsold goods. The latter will have to be discounted in order to sell, creating a substantial hit to profitability. It is a similar picture in Europe as well.
In terms of market style factors so far this year, so-called “value” stocks (a stock whose share price is trading below its intrinsic value) have been the best performers. The value space includes energy and material companies but also many banks and insurance companies, which have benefited from the perceived positive impact of higher interest rates on their interest-earning assets such as their loan and bond portfolios.
In contrast, the performance of “growth” stocks (those companies expected to grow sales and earnings at a faster pace than the market average) has unsurprisingly been poor, reflecting an ongoing trend that started in late 2021 when the Federal Reserve began highlighting the likelihood of higher rates in response to inflationary pressures. Growth stocks are typically assessed on the basis of future earnings and cashflows: higher interest rates negatively impact the discount rates used to value these flows.
Whilst the underperformance of growth as a style is perhaps not surprising, it is notable that the “quality” factor, which typically includes companies with higher and more reliable profits as well as low levels of debt, has also been a marked under-performer. Although about 40% of quality stocks are technology companies, a large proportion of these are established, cashflow generative companies with strong balance sheets such as Microsoft, Google, Adobe, Intuit and Texas Instruments. The remainder of the quality space consists of large, defensive compounding companies such as Johnson & Johnson, Eli Lilly, Visa and Coca-Cola. Given the magnitude of the drawdown in this space (-20% on average), we think there is a high probability of recovery in this area over the next 6-12 months.
We are monitoring the current recession-inflation balance very closely as it is in fact rather unusual. Many observers are comparing the current environment to the 1970s when inflation was rampant, and the cost-wage-price spiral became embedded before aggressive central bank action finally brought it under control after a period of extreme difficulty for markets. However, unlike in the 1970s, unemployment is at extremely low levels and in fact has been trending down.
You would have to go back to 1951 to find a period where inflation was higher than 8% in the US and the unemployment rate was below 4%. In fact, since 1948 there have only been 15 months when there has been such polarisation between inflation and unemployment. Each time this has happened there has been an economic recession within 18 months, followed by a period of relative stability and growth. Based on that statistic, it certainly seems likely that we will experience a recession, but the comparison suggests that there could also be a relatively swift normalization in the global economy following that.
Let us hope that this does prove to be the case. There is a fine line between managing inflation (through interest rates whilst preserving confidence and growth, and central banks may well yet fail in that endeavour. Our base case is predicated on a successful central bank response, but clearly there is a risk that the momentum of inflation proves unstoppable. A perfect storm of this order would certainly be a considerable challenge for both equities and bonds.
The strength of commodity prices is providing an extraordinary uplift to the earnings and cashflows of energy and mining companies, with many of these theoretically able to buy back their entire share capital within five years based on the current run rates. Against that backdrop it certainly makes sense to retain exposure to these areas for the time being.
However, for both consumers and corporates, the combination of rampant inflation and rising interest rates (after a long period of cheap money) is already having a negative impact. “Demand destruction” is making itself apparent in many areas, from consumer spending patterns to corporate investment. Many companies will find it difficult to raise prices in such an environment and earnings disappointment will follow. Although markets have fallen substantially, the negative trend in earnings means that they may not be as cheap as they look.
Our focus therefore remains on pricing power: the ability to pass through cost increases without compromising demand. There are industries where pricing power is generally quite strong: healthcare for example is an area driven by innovation, where many companies have one or several unique products that give them the ability to sustain pricing and grow earnings.
Technology, particularly in software but increasingly also in leading edge semiconductor manufacture, is another area where individual franchises are ring-fenced and sought after, allowing these companies to prosper in difficult times. Very few people will want to stop using Microsoft Office: indeed, in a recessionary environment they may want to use it more than ever.
For understandable reasons the market is currently incredibly focused on the short-term picture. News flow change is constant, sentiment is quite negative, and volatility is high. Taking a step back however, the market seems to have lost sight of some of the key underlying trends that are likely to dominate our lives for many years to come. Climate change is a reality, and yet climate-related companies have fared relatively poorly in recent months as investors have focused on the price of oil, coal and other energy commodities.
Digitalization is a reality that is accelerating hugely behind the scenes, and yet technology has been one of the weakest areas in the last 12 months. Advances in biotechnology continue apace, but again the space has been marked down heavily post-pandemic. In each case, opportunities are opening up for investors with the ability and patience to look through current market turbulence. We think that the long-term pay-off for investment in these areas of structural growth will be immense.
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