Equities Focus April

Summary

1. Upgrading US stock view to Neutral: we believe that there is room for this stock rally to run. However, given key ongoing uncertainties around a) how far the Federal Reserve will raise rates, b) how high commodity-influenced inflation will stay and c) how much the US economy will slow, we are only raising our view to Neutral at this stage.
2. Neutral equities overall: we remain Neutral overall on Equities as an asset class (including in Europe, Emerging Markets), as we await further potential reduction in uncertainties.
3. Selective opportunities in Tech: the US economy, corporate cash flows and earnings all continue to demonstrate strong resilience. We upgrade the US Technology and US Consumer Discretionary sectors to Neutral (from negative).
4. Key Risk: can the US Federal Reserve really raise interest rates 8-9 times this year in an already-slowing economy? I have my doubts. I think the Fed is likely to soften their discourse in the coming months. If not, recession in 12-18 months?

Key recommendations

• Favour global Metals & Mining exposure (Positive view): nickel, tin and aluminium prices have hit new multi-year highs, with current warehouse inventories at record lows and supply potentially constrained by the lack of Russian exports. We remain Positive on both industrial and precious metals commodity producers.
• Latin American, Canadian and UK equities outperform on the back of outsized commodity producer exposure: in other words, large weightings in industrial and precious metals producers, plus the oil & gas sector are driving outperformance of these three regional markets.
• Buyback strategies favoured: conservative investors looking for high quality, total shareholder return yield (dividends + buybacks) can find an outperforming solution in US and global stock buyback strategies, with companies flush with free cash flow and high profit margins.
• Circular Economy theme in focus: very high energy and raw materials prices underline the need to optimise our use of natural resources – the focus of the circular economy model.

1. Global Equities Outlook: Europe vs US

A near-30% PE discount for Europe v US stocks

While valuations have declined globally for stocks, the de-rating has been more severe this year in Europe than in the US, due to the greater perceived risk of at least an earnings recession in Europe due to the combination of geopolitical volatility and the heavy burden of record energy prices on the European economy. Today European stocks are 29% cheaper in PE terms versus the US, despite a higher European weighting towards Oil & Gas and Mining.

Energy costs and recession risk weigh on Europe

The impact from the Ukraine conflict, record energy prices and the ensuing risk of recession put investors off investing in European equities, with the relative safe haven (i.e. the US) preferred in February and March 2022.

This preference is likely to continue until natural gas, electricity and oil prices come down more meaningfully in Europe. Today, energy costs represent over 9% of European GDP, the highest level since the early 1980s.

2. Focus: the Inverted Yield Curve

An “inverted yield curve” is not the end of the world

Each of the last 6 economic recessions occurred after this 2y-10y US yield curve had inverted (turned negative). Recessions tend to be bad for economically-sensitive risk assets - stocks, high yield credit, real estate and private equity. An inverted yield curve is not the catalyst that sparks a recession, but highlights that bond investors are worried about the US economy’s long-term growth prospects. Not every yield curve inversion leads to recession (e.g. 1994, 1998).

Stock markets peak 10 months post yield curve inversion, on average

Even if the current US bond yield curve inverts (i.e. 2-year bond yield above 10-year yield), this does not guarantee that a recession is coming. We look for a downturn in cyclical employment as confirmation of looming recession. Even if a recession is signalled, it may still not occur for 2 years or more. Stock markets have usually gained (average of 12%) for approximately 10 months after a yield curve inversion. Favour defensive sectors post inversion e.g. Health care.

3. Asian Equities overview

Potential catalyst required for Chinese rally to be sustainable

• After Beijing’s recent pledges to ensure financial market and economic stability, the Chinese equities market produced a strong bounce after the recent selloff. Despite the rally, valuations still look attractive, and there are potential catalysts to monitor in ensuring a sustainable rally.
• China’s “zero-COVID” policy remains a hurdle for the economy. The spike in COVID cases in China has led to more lockdowns. However, Shanghai’s recent two-phase shutdown shows the authorities are now less stringent. Some manufacturers have also been reported to continue operations during lockdown. This may help to mitigate some risks to global supply chains and China’s 5.5% GDP growth target.
• Chinese technology and other companies are announcing large share-buybacks to take advantage of cheap valuations. This caps downside risk and reflects the confidence of management in the long-term prospects of companies. There are also ongoing discussions over cross-border auditing regulations to avert de-listings in the US, albeit still “premature”.
• Investors are also awaiting specific measures to achieve stability in the property market. The expectation is for further monetary easing, and an improving credit impulse will likely be positive for Chinese assets. We continue to prefer domestic China A-shares as they would benefit directly from policy easing.

4. Sector Allocation

We return to neutral on US equities, US technology & US consumer discretionary

As long as the full consequences of the conflict in Ukraine are not known, we recommend staying relatively prudent and well diversified. Inflation figures remain very high and bond yields are rising. However, risks seem better priced in now than in early February, hence our upgrade of US technology and of US Consumer Discretionary (both from – to =).

• We have evidence that companies are still spending heavily in their IT systems and, as a consequence of the war, they might have to spend even more. Cybersecurity is an obvious candidate for extra spending.
• Most ‘Mega Tech’ companies have become less cyclical (increasing recurring revenues), are cash-rich, demonstrate good pricing power and are able to buy back shares. Big Tech now even pays more and more dividends.
• Order books are full, and many traditional companies still have to upgrade their IT systems, connectivity, cybersecurity, cloud systems, etc. Long-term growth looks certain in the tech sector.

Due to persistent uncertainties (Ukraine, energy crisis, high inflation, tightening monetary policies, rising bond yields, French elections), we remain prudent but not pessimistic. In the West, economic growth should still prevail, micro fundamentals look solid, and most restrictions relating to COVID-19 are being lifted. These factors constitute counterweights. But selectivity is needed.

• Despite higher energy prices and despite the gloom surrounding the conflict in Ukraine, a significant slowdown in consumption in the US does not seem to have occurred so far. Latest figures from some major companies, such as Mastercard and Visa, confirm this supposition. Other surveys show that many Americans still plan to buy big ticket items.
• In the meantime, investors have reduced their exposure to technology and consumer discretionary (in favour of commodities, energy, consumer staples and healthcare). As these 2 sectors are much less overweight today in many portfolios, they have room to recover. Therefore, our recent upgrade of US Technology and US Cons. discretionary sectors to Neutral (but be selective as many names still look expensive). 

6. Recommended portfolio positioning

Stay hedged against inflation

This year, we have been strongly advocating portfolio hedges against inflation, with the following as the main beneficiaries: commodities, particularly metals and mining (oil is marking a pause at the moment), European real estate, but also some select US real estate and some financials (preference now for insurers and diversified financials). Earnings revisions also support these sectors. Companies with pricing power have also recorded much better performance.

In addition to inflation beneficiaries, favour defensive sectors

The global economy is cooling down and many investors are increasingly nervous given the flattening/inversion of the yield curve. We do not foresee a recession in 2022, but we believe in staying somewhat more defensive in the short term. Our favourite defensive sector, Health Care, has been the best sector in Europe since Russia invaded Ukraine. Other defensive areas in the market, such as high dividend strategies, have also outperformed.