Equities Focus October

Equities at a glance

Key Points

1.Will the US stock market definitively break the June lows? US stock market indices have returned to the June lows, as a combination of tighter financial conditions (including a stronger US dollar) and higher long-term real bond yields continue to put pressure on both earnings and stock valuations.

2.We could well be at an important turning point for stock markets, if financial conditions (including the US dollar) and real yields are peaking now, as we suspect. Recent improvement in US economic data could also support near-term earnings trends.

3.High volatility levels point to better returns. Since 1990, the highest 10% of VIX volatility index levels  (VIX>29) have typically preceded strong periods of subsequent US stock returns. Over 1 year, post a high VIX reading, US stocks have returned 24% on average over 1 year, and 39% over 2 years. Today’s VIX of 32 underlines investor fears, but suggests strong returns going forwards.

Key recommendations

Energy Producers
Overweight sectors provide a hedge against high inflation. European sanctions against Russia (embargo on Russian oil to start in December) and the recently-announced 2 million barrel/day OPEC+ production cut support the sector. This very profitable sector is still extremely cheap.

UK, Japan, Share Buyback + High Dividend equities
UK: energy exposure, cheap with currency benefit, high yields, stronger growth.

Japan: the Japanese TOPIX index is finally breaking out versus the US S&P 500, signalling further potential outperformance ahead.

Key Risks: still no pivot yet from the US Federal Reserve, as US inflation has not declined sharply. The ISM manufacturing survey looks set to dip below 50 to follow the Markit composite PMI, which has typically been a drag on US corporate earnings.

1.Financial conditions, real yields, USD fall

Financial conditions have loosened a little

US and European financial conditions have loosened a little as volatility and credit spreads have narrowed. But higher interest rates and the start of the Federal Reserve’s balance sheet reduction are preventing financial conditions from loosening much more. Lower US inflation prints and less aggressive communication from the Federal Reserve about future interest rate hikes are needed to loosen financial conditions further, triggering a risk asset rally. 

US 1-year inflation expectations fall sharply

Huge decline in 1-year inflation expectations: 1-year US inflation swaps price CPI inflation at 2.7% in 1 year’s time, versus a peak of 6% mid-year. A large number of inflation prices components are starting to fall sharply, including: housing, gasoline, goods like used cars, logistics/trucking costs, and construction materials like lumber. This is also reflected in the falling prices paid components of the ISM manufacturing and non-manufacturing surveys.

2. Don’t be scared of volatility

Post high VIX Volatility, stocks perform strongly

Don’t be scared of the current high stock market volatility levels (VIX index at 32). Yes, investors have been buying put option protection for stock portfolios at an unprecedented rate, judging by the latest US equity put/call ratio.

But statistically speaking, over the last 30+ years the highest VIX volatility index levels have typically preceded strong periods of subsequent US stock returns. Over 1 year, post a high VIX reading US stocks have returned 24% on average over 1 year, and 39% over 2 years. 

Record pessimistic institional + retail investor sentiment

Professional investor sentiment at record lows: professional investor sentiment is measured by the NAAIM and Investors’ Intelligence sentiment surveys. These two surveys combined with the retail AAII sentiment survey reveal a level of pessimism only ever seen in the depths of the 2008 financial crisis. We see this as an excellent contrarian indicator, as it was at end-2008 and again in late 2015. Combined with record short positions on index futures and record put protection option buying activity, this underlines the potential for a market rally.

3. Halloween Effect: Positive seasonality

November-April, S&P 500 performs much stronger

From early October to the end of April, the US S&P 500 has typically gained 8% (2001-2021 average), in contrast to a flat performance from May to start-October. In Europe, the German DAX index has on average risen by 9% over this same winter/spring period.

Add to this the US Presidential mid-term year effect, a year when US stocks have traditionally performed well.

Seasonality effect strongest in UK, Europe, Japan

Over the last 20+ years, the Halloween Effect has been strongest in the UK and Europe, with outperformance of as much as 10% for Europe from the beginning of November to the end of April, as compared with the May-October period.

Note also the strong seasonal effect evident in Japanese stocks, a region we continue to favour given the benefits of a weak currency, rising profitability and dividend payments, and attractive valuations. 

4. UK assets look attractive post mini-budget

Financial markets drove 30-year UK yields up, sterling down post budget

Surprise tax cuts introduce volatility: following the recent UK tax-cutting mini-budget, UK assets (FX, bonds, stocks) have experienced a sharp sell-off as investors worry over the UK’s long-term debt sustainability. In all, sterling has depreciated against the US dollar by nearly 22% since May 2021.

The latest extreme increases in UK bond yields obliged the Bank of England to step in with an emergency bond-buying programme in an attempt to calm this financial market stress. 

Post mini-budget, a buying opportunity in UK FTSE

Buy UK large-cap stocks: for non-GBP based investors, the 24% drop in US dollar terms in UK large-cap stocks presents an excellent opportunity to buy the UK FTSE 100. Recall that this a global index which generates over 50% of its earnings from overseas in US dollars. Aggregate FTSE 100 earnings are thus expected to grow over the next 12 months. The FTSE is attractive given the cheap valuation level (< 8x forward P/E, 4.8% dividend yield), heavy commodity and defensive sector exposures and a cheap currency.

5. Long-term threat to growth stocks: Millennials

Huge drawdown in US financial wealth in 2022

Believe it or not, the current sell-off in stocks, corporate credit and sovereign bonds has already resulted in far more damage to investors' wealth than the Great Financial Crisis in 2008!  Indeed, in 2008, total loss of value in US stocks, credit and bonds totalled less than USD10 trillion at its worst point. So far in 2022, the fall in value of US stocks, credit and bonds has reached nearly USD58 trillion, more than 6 times more than at worst in 2008. 

Younger investors have potentially been scarred

But it seems to be far worse for Millennial investors (between 26 and 41 years old today). They had disproportionately invested in growth/technology stocks, in particular chasing the latest hot investing trends. Since November 2021, the US meme stock index has fallen 70%. Cryptocurrencies such as bitcoin have fallen 73% from November 2021 peak. Hardly surprising then that Millennials have been heavy sellers of their investments over the last 12 months. Will this experience scar them for life?

6. Earnings expectations

Inflation in the US is now hurting revenues and margins

In the US, revenues are now expected to grow by +8.7% YoY for 3Q22 (down from +9.7% YoY estimated on 30 June) and earnings are also continuously being revised down: now +3.2% YoY earnings growth in Q3 (compared with the estimates of 9.8% YoY growth rate at the start of the quarter). Ex-energy, Q3 earnings are estimated at -8.2% in the US.

Cyclical sectors look the most at risk in the US, due to the slowing down economy, rising costs and persistent supply chain issues.

Valuations are still rich in the US (forward P/E lies around 16), particularly in the tech, consumer discretionary and staples sectors, where some companies are still trading at P/Es way beyond 20. We are now observing lots of downward revisions.

Earnings in Europe are supported by energy, basic MATERIALS and financials

Q2 earnings season was good in Europe. Expectations for H2 2022 and 2023 have remained stable. Obviously, the weak USD and commodities related companies have been pushing up European earnings forecasts, expected to grow at +30% Y/Y in Q3 3022. In 2022, earnings are expected to grow +18% in Europe whereas in 2023, they are expected to grow little. Of course, a lot will depend on how fast countries find solutions amid the geopolitical tensions and energy crisis.  Including the recent revisions, Europe is now trading at a forward P/E of less than 11, almost its recent trough, which was reached at the height of the COVID crisis. Sectors that perform well during times of inflation are particularly cheap at the moment: Energy and other Commodities, Financials, but also Health Care. 

7. Sector Allocation

Too early to significantly add beta but profit from depressed levels to accumulate

Interest rates and yields are rising fast. At the same time, a deep recession starts to be priced into some cyclical sectors, such as the Banks. We believe that with pessimism so high, investors should profit from these new market troughs to accumulate solid value and growth names at depressed levels. 

Investors should hold sectors that perform well during times of inflation, such as Energy, some Metals & Mining (related to energy and the energy transition) and select Financials.

European sanctions against Russia (embargoes on Russian oil to start in December) and OPEC+ cutting their production support the sector. This very profitable sector is still extremely cheap.

Though we are cautious about the Banking sector due to the global economic slowdown, Financials are cheap in general. Financials’ forward P/E is 11.2 in the US and only 7.9 in Europe. Balance sheets look very solid; cash flows, profitability and dividends are very high. 

We still advise to keep a good chunk of any equity portfolio invested in companies with pricing power and/or returning big amounts of cash to shareholders. Among defensives, we still prefer Health Care. 

European REITs also trade at bargain prices (discounts to NAVs and dividend yields stand at multi-year highs), after a collapse this year, due to bond yields rising sharply.

Some Technology and Communication Services also start to look more appealing after their sharp derating.

On the other hand, Cyclical and Consumption stocks which are sensitive to the global economy, a likely slowdown in consumption and supply chain issues (Industrials, Consumer Staples & Discretionary, Materials) are likely to underperform in the short term. Be very selective there.

Major corporate Q3 results, being released from 14 October, will help determine which companies  are resilient to the economic slowdown