- Equity markets survive September swoon in resilient form: stock momentum remains strong on a) abundant liquidity; b) surprisingly strong Q2 earnings results, driving positive earnings forecast revisions; c) vibrant economic growth despite Delta variant doubts; d) real yields still negative and close to rock-bottom. We retain a positive view on global equities.
- European inflation expectations have been rising more consistently than in the US since April 2020, doubling from 0.9% back then to 1.8% today. In the past, European value stocks have outperformed growth stocks when inflation expectations have risen significantly.
- Inflation expectation beneficiaries: Banks, Life Insurance, Oil & Gas, cyclical value stocks have started to outperform on the back of rising inflation expectations – a trend we expect to continue. Favour financials, oil & gas sectors.
- Opportunity in small-/mid-caps Post a 6% pullback in September, European smid-caps present an excellent buying opportunity. Given the higher exposure of this segment to Cyclicals/ Industrials, we expect further SMID outperformance ahead.
- China Crisis: on hold, awaiting news on an Evergrande restructuring deal that could prevent property market contagion. Emerging Markets ex China are doing well, buoyed by positive exposure to energy and metals.
Global Equities view
Line up cyclical value for the rest of the year
There are two powerful reasons for looking hard at cyclical value stocks for the rest of the year, now that we have entered Q4.
These two reasons are:
1. Rising inflation expectations, and
2. Winter seasonality
Put simply, value stocks tend to outperform when inflation expectations are rising, as these rising expectations usually reflect higher nominal growth in the economy, which tends to boost the growth and profitability of more cyclical sectors and stocks.
Inflation is set to remain higher for longer: guess what? With the surge in inflation rates driven by a whole host of factors, including supply chain disruptions, surging food and energy prices and rising wages as employment recovers, inflation expectations are unsurprisingly on their way higher.
Inflation to persist above central bank targets
US growth v value: In the US, for example, growth has beaten value by a distance over the last few years since 2014, as long-term inflation expectations fell from around 3% to as low as 1.5% in mid-2020.
But today, with US CPI inflation rates running at over 5%, inflation expectations are increasing, currently at 2.2%. The more that these expectations rise, the greater the chance that US value stocks will outperform growth, as happened in the early 2000s. With the CPI implied cost of shelter component lagging actual house price growth by about 18 months, US inflation is set to remain high for some time to come.
In Europe, household energy prices make up nearly 6% of the eurozone CPI weighting. And as we are all about to find out in our household utility bills, natural gas and electricity prices have been surging of late. So don’t expect European inflation rates to settle down any time soon, particularly if we see a harsh winter.
The combination of inflation breakevens at/below 2.5% (2.5% in the US, 1.7% in Germany) and the rising trend in real yields has historically been good news for equities, with US stocks typically gaining 12% over a year under these conditions. Inflation breakevens above 2.5% in the US would point to an even better outcome for equities (+15.5% on average), so long as this is accompanied by solid real economic growth.
Q4 = Favourable seasonality for Cyclical Value
What does best in a rising long-term rate cycle?
Now that September is behind us, we enter the last quarter of the year with favourable seasonality for European cyclical stocks. Since 2005, European cyclical stocks (as defined by STOXX) have posted an average 5.4% return over Q4, versus only 0.9% for defensive stocks.
As you can also see from the chart below, this cyclical outperformance tends to continue at the beginning of the following year as well, up until the end of April.
Focus on Oil & Gas, Miners, Banks
The three sectors that I think typify cyclical value in Europe today are the Oil & Gas, Mining (Basic Resources) and Banks sectors.
Since 1992, the European Oil & Gas sector has posted a 3.2% average gain over Q4, while Banks have done better at 4.5% on average, and Miners best of all at 5.5%. Over the full October-April 7-month period, Miners have posted an average gain of over 14%.
Within Oil & Gas, favour natural gas exposure: while crude oil prices have almost doubled since November last year (from around $37/barrel to $76-79 now), it is natural gas prices in Europe that have really exploded in bitcoin-like fashion.
The combination of lower-than-normal electricity generation from wind power, higher demand as economies post strong growth and below-average levels of natural gas storage have all combined to form a perfect storm for natural gas prices. European and US oil & gas companies with a high proportion of revenues from natural gas production will naturally benefit from this, with US shale gas producers to benefit in particular.
In addition, utility electricity generators which are able to sell nuclear- or hydro-generated electricity in Europe should also benefit from extremely high wholesale baseload electricity prices.
Bond yield beneficiaries
Which sectors do best in a rising long-term rate cycle?
In the current climate, the sectors that should perform best are Financials, Energy (oil & gas) and Value equities.
In fact most cyclical stocks outperform against a backdrop of rising yields as the latter typically reflect the economy's good health (strong growth). However, today we must remember the difficult context in China and the recent boom in energy prices. As a result, Industrials, Consumer Discretionary and Basic Materials are under pressure in view of their fairly strong correlation to Chinese demand, which is slowing. In addition, rising costs, especially energy, are squeezing margins in these sectors. Finally, if consumers pay more for energy bills, they have less to spend on other expenses.
Overweight Financials and European energy!
We believe the strong recovery in growth is likely to continue in the medium term. This will allow banks to increase their lending (with fewer defaults), grow their trading/market/investment banking revenues, as well as their business in general. Intermediation margins and Net Banking Income will increase as the yield curve steepens.
This will occur in a context in which banks have restructured significantly in recent years, resulting in very strong balance sheets, a better cost structure, less volatile revenues and even renewed growth, particularly in asset and wealth management.
This is leading to higher cash flows and more profits in general, which will also result in better returns for shareholders through higher dividends and share buybacks. For example, Crédit Agricole has announced share buybacks, something that had not happened at a European bank for many years. Other banks have since followed suit.
Despite their solidity, renewed profitability and rising prices this year, European banks’ price-to-earnings ratios remain below x10, which is very cheap on a historical basis and in the current context of an economic recovery. According to Bank of America, the dividend yield could reach 7.4% in 2022! Not to mention the numerous expected buybacks of proprietary shares.
Insurers also usually benefit from a firm economy. Their investments tend to appreciate in such context. On the other hand, the discount rate for future life assurance payments increases when yields rise and, therefore, the amount of their future payments discounted at today's date falls. This has a positive impact on the company's valuation.
Bond yield beneficiaries
A rising trend in yields is positive for insurers, especially in the case of life assurance or guaranteed income pensions. However, a strong inflationary shock leading to a sudden rise in yields would hurt the value of insurers' assets.
Finally, the uncertain world in which we live has created new business opportunities, linked to Covid-19 and other illnesses, but also to cybersecurity, and hurricanes/other bad weather events, etc.
Therefore, insurers have much more reason today to hike the premiums that customers pay compared with previous years.
Like banks, insurers' balance sheets are strong, restructuring is deep, and sector profitability elevated.
European insurers have price-to-earnings ratios of around x10 as they pay out some of the highest dividends in the market.
Energy (oil & gas)
This sector benefits from the rise in oil and gas prices, the reopening of economies and the resumption of travel. Based on our estimates, the market is pricing in oil prices at less than $60 per barrel, whereas we expect oil prices to remain above $70 in 2022.
According to analysts' consensus, European majors are valued at P/E ratios of around x8 (and even less according to BNPP Exane) whereas their free cash flow and dividends are among the highest in the market. We prefer Europe to the US which trades at P/E ratios above x12 on average although they have made much less progress with their energy transition.
Sectors affected by the energy crisis and rising energy efficiency
Apart from the fact that the slowdown in China is affecting demand for materials, industrial equipment and consumer discretionary goods (the main reason that we have been relatively cautious on these sectors in recent months), rising costs, particularly energy, are affecting many companies in these fairly energy- intensive sectors. Don’t panic too much at the moment, as many companies are trimming costs, gaining in efficiency or passing on these cost increases to end prices. However, Evergrande's contagion to the Chinese real estate sector as a whole could put certain materials and cement companies (exposed to it) at risk.
Rising yields also affect relatively expensive stocks in growth sectors such as Technology, Consumer Goods in general, some Utilities and Healthcare.
Trend in corporate profits
The American earnings season kicks off on 13 October, with the ‘mega banks' getting the ball rolling. We should have a first indication in other sectors. Generally-speaking, earnings estimates are under pressure in view of the supply and delivery woes experienced by many companies. On the one hand, demand is robust, with even stock replenishment. But on the other hand, there are production concerns linked to the pandemic (forcing plants to produce less, or even close down) not to mention rising energy costs.
So we will need to identify which companies (or which sectors) have been the worst hit by the present context (probably Consumer Goods, Industrials, certain Materials companies, Utilities, or even Technology equipment-makers). Forecasts for Q4 2021 and even for 2022 will be even more important to watch than the disrupted earnings in Q3 2021. We remain optimistic about 2022.
Note that companies that have already issued a profit warning have since underperformed on the stock market, and vice-versa for companies that have announced upward revisions.
In Europe, too, some profit forecasts have been revised down, albeit slightly at the aggregated level. Admittedly, the rise in the greenback, social aid, stimulus plans, and high rates of vaccination against Covid-19 (among the highest in the world) are driving Europe’s economic recovery.
Earnings forecasts for 2021 are 21% higher than at the start of the year and no less than 13% higher than FY 2019 earnings. The analysts’ consensus is for earnings growth of around 7% in 2022 and 2023. The Stoxx600 Index looks relatively cheap: price-to-earnings ratio is around x15.2 expected earnings in the next 12 months. The US remains relatively expensive with a forward price-to-earnings ratio of just over x21.
Sector-wise, as expected, the largest upward earnings revisions are in Energy. Other cyclicals are also seeing some upward revisions but this is not the case for Consumer Goods and Utilities.
Corporate earnings expectations are down slightly at the moment (especially in Q4 2021) as they are facing cost increases. But it appears that most manage to secure their profit margins. The Q3 2021 earnings releases will confirm (or not) this point. We remain optimistic for 2022.
Rising bond yields favour Cyclical Value stocks
Early last summer, Technology and Defensive stocks delivered a better performance, catching up with Cyclicals (which had strongly outperformed earlier in the year). However, after the Fed announced that inflation could remain longer than expected, and tapering could occur quite soon, bond yields started to rise, now favouring Value/Cyclical stocks again.
Reversing the trend seen in early summer, the top-performing sector in September was Energy (almost +10%), and it was the only sector to remain in the black in the US! In Europe, Financials and Autos also gained ground.
Several sectors (mainly Materials, Industrials and Consumer Discretionary) came under pressure due to their dependence on China, and the slowdown in global economic growth, Many suffer from rising (energy) costs.
YTD, our favourite sectors are doing well: Financials (+) and US Real Estate (+) are outperforming. Energy (the very cheap European energy sector is in ‘+’), Health Care (+) and Tech are also performing nicely.
No changes this month: stay diversified and selective!
Sell into Tech strength: we continue to recommend reducing weightings to ultra-long duration US Technology; We focus on reducing names with disappointing, weak or no earnings (in general, expensive names have been underperforming over the last few weeks; see chart below).
However, Semis (+) still have potential due to the unmet demand and their pricing power. Other opportunities found in the fast-growing tech segments include Artificial Intelligence, 5G, Cloud and Cybersecurity.
We remain positive on Health Care, Financials and European energy due to their huge cash flow generation, supporting dividends and share buybacks.
Battery metals (copper, lithium, nickel) are the best ways to play the American and European renewable infrastructure plans. We also like Construction Materials as long as China avoids contagion from Evergrande to financial markets.
We recommend a sound diversification, favouring the cheapest sectors with good or improving cash flows among cyclicals and defensives. Financials, Health Care, Real Estate, Precious and ‘battery’ metals, Construction Materials, Semiconductors and EU Energy look good. On the other hand, avoid Utilities and sub-sectors suffering from rising costs and bond yields such as Household and Personal Care products (‘HPC’). China Crisis
Surprisingly resilient domestic Chinese equities: the headlines from China have shifted from the broad regulatory tightening to the big property developers’ funding pressures. Offshore Chinese markets have suffered, with the Hang Seng China Enterprises Index down 6.4% month to date. Despite contagion risk concerns from Evergrande’s debt difficulties, the onshore A-shares market has remained resilient with the CSI 300 Index up 1.5% MTD.
No Chinese Lehman moment: we disagree that the Evergrande crisis is China’s “Lehman moment”, and expect the Chinese authorities to avoid the worst-case scenario of disorderly bankruptcy and full liquidation of Evergrande and other large property developers.
Asia Markets (financial press) reports a deal that will see China Evergrande restructured into three separate entities is currently being finalised by the Chinese Communist Party and could be announced within days. State-owned enterprises are said to underpin the restructuring, effectively transforming the property developer into a state-owned enterprise.
Evergrande scrambles to sell assets: Evergrande is looking to sell assets to raise cash, including its 50% stake in Evergrande Life Assurance Co., which could raise USD 600m.
Evergrande has 30 days from non-payment of dollar bond coupons before a default is declared: its 2022 USD bond had a coupon due on 23 September, with four more USD coupon payments due by 11 October.
Thus Evergrande has until 22 October to start paying these coupons if it wishes to avoid defaulting.
More monetary easing measures ahead: given the weaker-than-expected economic data plus the ongoing regulatory tightening campaign to achieve the central government’s long-term goal of “common prosperity”, we expect more selective easing measures in Q4 2021. We note that China’s credit impulse has been bottoming out recently, with the PBOC injecting a net 100 billion yuan into markets on Monday 27 September.
Expect further short-term volatility as Chinese authorities try to arrange an orderly restructuring of Evergrande, which is not at all guaranteed as of yet.
Investors who able to take a long-term multi-year view may look to buy exposure to China via domestic A –shares, or even better, Chinese domestic mid-/small-caps.