Equities Focus March
- We downgraded our stance on equities to neutral (from positive) in mid-February: we downgraded our regional equities views as follows: US to negative (from neutral), Europe to neutral (from positive). This change was motivated by a) the breakdown in upwards momentum trends, b) sharply rising macro risks, and c) persistently high inflation weighing on consumption.
- Commodity prices hit the stratosphere, favouring Basic Resources: industrial metal prices have soared to new multi-year highs, with structural demand underpinned by electrification of the global economy and supply heavily constrained. Best-performing sectors: Metals & Mining, Oil & Gas, Agribusiness.
- Key risks: huge uncertainty over Russia/Ukrainian conflict, with the impact of a lasting step-change in energy and food prices increasing the risk of a potential global recession.
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 is driving outperformance of these three regional markets.
Sector changes: mid-February, we downgraded US Technology and Consumer Discretionary to negative given the growing pressures on the US consumer, both from elevated headline inflation and from prospective US Federal Reserve rate hikes.
Banks downgraded to neutral due to the uncertain global consequences of the war and of the sanctions against Russia.
1. Equities at Neutral
Risk management drives equities downgrade
Why we downgraded our equities stance to Neutral from Positive?
Elevated energy prices act as a global “tax”: the combination of elevated natural gas and crude oil prices (Brent crude oil at USD127/barrel at present) continue to act as a global tax on the global economy. The longer this remains the case on the back of escalating Russia/Ukraine military action, the greater the effect on slowing global growth.
High inflation impacts consumer spending: the high inflation rates suffered by US households in particular has already translated into sharply lower consumer sentiment, the lowest since mid-2020 (depressed by the first COVID-19 pandemic wave). This in turn is translating into lower forecasts for near-term US economic growth (Q1 2022 Atlanta Fed GDPNow indicator suggests only 0.5% annualised US GDP growth).
Inflation rates will decline, but timing remains uncertain: we believe that inflation rates are likely peaking soon. The key question is: how quickly will they decline? This will depend to some extent on the evolution of energy prices, which remains very uncertain.
Equity, credit valuations likely to cheapen, near term: we have been positive on equities as an asset class for several years. But we want to manage the rising risks to stocks, locking in 2021’s impressive stock market gains
Positive on equities longer term
Constructive view on equities, medium to longer term
There are many reasons to hold a longer-term positive view on equities:
a) robust earnings and cash flow growth, supported by
b) above-trend real and nominal economic growth (aided by government infrastructure programs),
c) long-term real yields still well below zero,
d) high levels of accumulated savings, and
e) a forthcoming boost from the elimination of COVID-related mobility restrictions globally, particularly for growth in services.
What could drive an equity upgrade back to positive?
a) Lower oil prices on any de-escalation of Russia/Ukraine conflict,
b) a clear sign of easing goods inflation pressures (from supply chain improvement),
c) Easing financial market stress/volatility levels in stocks, credit and liquidity markets, and
d) service sector rebound from a continued decline in Omicron COVID infection rates, leading to a release of remaining restrictions.
2. Global Equities Overview
Equity markets enter correction territory in 2022 YTD
February-March so far has seen continued correction in developed market equities: while eurozone equities have suffered most with consumption-related sectors Retail, Autos, Banks and Travel & Leisure falling furthest over the last month. European and US commodity-related sectors have managed to rise modestly over the last month, while Latin American equity exposure has benefited from heavy commodity-related exposure.
Metals and mining companies to generate record profitability
Multi-decade high industrial, gold prices boost miners: commodities have exited their 2008-2020 longstanding bear market with a huge price surge over the last year and a half. The surge in metals and mining company share prices reflects the expected record levels of profitability and dividend payments to be delivered in 2022 and beyond by global mining companies on the back of these record metals prices.
3. Bearish Investor Sentiment – Contrarian Signal?
Implied volatility rises to extremes as investors buy protection
The VSTOXX volatility index hits 45, nearly double its long-term average: the VSTOXX volatility index measures the volatility of the Euro STOXX 50 index. Extremely high VSTOXX levels, as we see currently, highlight that investors are paying a high price for protection, typically via buying index put options. In the past, these extreme volatility index levels occurred prior to a rebound in European stocks, even during the 2000-03, 2007-09 and 2020 recessions.
Short-term contrarian positive signal
A contrarian buy signal? The AAII bull-bear survey had already indicated that US retail investor sentiment had hit pessimistic lows. Now we see ta similar signal from institutional investors (via the Investors Intelligence survey), also consistent with a relatively high probability of at least a short-term stock market rebound.
4. The case for staying the course
Historic stock market reactions to geopolitical events
Why hold stocks even through times of crisis?
Looking at 22 important geopolitical events stretching back to Pearl Harbor in 1941, the impact in stock markets has been surprisingly moderate in the vast majority of cases. The S&P 500 index fell less than 5% on average to the lows, and then took less than 2 months on average to recover from this market fall.
Note also that investor sentiment has also plunged to extremely depressed levels, judging from the AAII and Investors’ Intelligence bull-bear surveys. Historically, these depressed sentiment levels have subsequently led to strong stock market performance.
Fast forward to 8 March, and we observe that US and European stock markets have shed 12-14% since the beginning of 2022, with notable outperformance from the UK FTSE 100 index (-5% year to date), the Canadian S&P/TSX index (0% year to date) and Latin American bourses e.g. the Brazilian BOVESPA (+7%). Each of these regional indices have a heavy weighting to energy and mining commodity producers, which have performed strongly in recent months with the MSCI World Metals and Mining Producers returning 16% year to date.
5. Repositioning if geopolitical risk recedes
Banks, cheap cyclicals and ‘reopening’ stocks would benefit the most on a reduction in perceived risks
Our more prudent shift in asset allocation has been rewarded - equity markets have corrected due to the Ukraine conflict. High inflation will persist for longer than expected on soaring commodity prices. Economic growth will be impacted, and profit margins are coming under pressure on the back of higher costs and ongoing supply chain difficulties. In this depressed environment, sectors considered as more cyclical or risky have suffered the most:
• Banks: full consequences of the war and of the sanctions not clear yet
• Autos: soaring raw material prices and more supply chain issues
• Travel & Leisure & Consumer Discretionary: very high energy costs with direct impact on travel and an indirect impact on overall consumption
• Tech stocks: very rich valuations and consumer exposure have weighed.
Growth expectations were optimistic prior to the current crisis. These are now being revised lower. But we still expect +3.6% economic growth in Europe in 2022, whereas markets have priced in an economic and earnings recession. The STOXX Europe index trades at a 13x P/E, close to its lows reached at the peak of COVID-related uncertainty in early 2020. Governments and central banks then intervened, leading to a rapid stock market rebound.
Any reduction in current perceived risks could trigger a sharp rebound in equity markets, particularly in Banks, Autos and other cyclical sectors.
Utilities/ renewables/ infrastructure exposure is becoming more interesting as the West has committed to invest heavily, to reduce reliance on Russian oil/gas.
6. Asian Equities view
We can no longer classify EM equities as a single “BRIC”
How will EM equities be impacted by Ukraine tensions and the transmission effect of higher energy/food prices across emerging markets?
• Firstly, emerging markets are not a homogenous assortment of economies or financial markets. In fact, the current commodity shortages and the commodity bull market are positively impact resource-based economies like Brazil (equities +18% YTD in USD) and South Africa (equities +9% YTD in USD) given their heavy weighting towards energy and metals producers.
• In contrast, the recent upturn in commodity prices are a moderate headwind for economies that are net importers of oil. For example, in Asia the larger net importers as a percent of GDP include India 25%, South Korea +22%, Singapore +18%, and China +10%. Hence, the duration and extent of the oil price spike will be key in terms of impact on inflation and monetary policy. Foodstuffs (wheat, rice, soy) are also a larger percent of the household basket than in the developed world.
• However, in the medium term, emerging markets have implemented much less fiscal and monetary stimulus than developed countries. Furthermore, many countries like Brazil already raised rates aggressively last year. In addition, many Asian economies are only re-opening this year (excl. China). Hence, they do not suffer the same level of inflation or peak employment pressures as in the West.
• Finally, foreign exchange reserves and current account deficits on average are more restrained compared with prior periods - remember the “Fragile Five.” In fact, for instance, most emerging foreign exchange markets have sold off less than the euro and Eastern European currencies in the most foreign exchange recent sell-off.
• We remain neutral on overall emerging markets, given our neutral global equity view predicated on near-term cautiousness, and better risk and reward in the UK and Japanese equity markets.
7. Sector Allocation
WE TURN MORE DEFENSIVE IN OUR SECTOR ALLOCATION. US TECH & US CONS. DISCRETIONARY ARE NOW UNDERPERFORM.
GLOBAL BANKS AND EU ENERGY MOVE FROM POSITIVE TO NEUTRAL. AEROSPACE AND DEFENCE: FROM NEGATIVE TO NEUTRAL.
Inflation figures have been higher than expected over the last few months. Bond yields have risen and monetary policies are tightening. Expensive names and stocks of companies disclosing poor earnings have crashed. We are advanced in the correction but we consider that many stocks in technology and consumer discretionary are still vulnerable. Banks could also remain very volatile.
- We recommend continued caution until we see a stabilisation (if not a cooling down) in the Ukraine/energy crisis.
- Expensive sectors/stocks remain vulnerable despite recent sharp corrections. Mid-February, US Technology and Consumer Discretionary were downgraded to negative. EU Tech (much more exposed to semiconductors, a sub-sector we prefer in techno) and EU Consumer Discretionary are cheaper and we remain neutral.
- In the Tech/‘Metaverse’ space, for the medium term, we like semiconductors, 5G, cybersecurity, e-gaming, e-payments and artificial intelligence.
Due to persistent uncertainties (Ukraine, energy crisis, high inflation), hitting consumer confidence, we are increasingly prudent but not pessimistic. In the West, economic growth should still prevail, corporate results have been quite good and most restrictions relating to COVID-19 are being lifted. All these factors constitute strong counterweights. But selectivity is needed.
- We retain an overweight exposure to sectors and asset classes acting as hedges against inflation, such as metals and mining, some financials and European real estate.
- However, Banks are downgraded to neutral due to the uncertain global consequences of the war and the sanctions against Russia.
- Also, oil and gas prices are now incorporating a lot of tailwinds. Supply could improve fast (Iran, US shale) and Russia continues to export. We therefore downgrade EU energy to neutral after strong outperformance.
- We like Healthcare (+), as it is still relatively cheap, showing good cash flows and secular growth.
- The Aerospace and Defence sector has been upgraded to neutral for obvious reasons.