Chaleur et lumière
The mercury has been at the top of the chart in Europe over the last week. This has encouraged more topical discussions about climate change and what needs to be done. I will return to that theme in the near future but suffice to say, asset owners and managers get it and are incorporating climate risks and mitigation metrics into their investment decisions. That train is not going back to the depot. As well as feeling hot, it feels like investors are weary of chasing the bear story and may even see some light in the tunnel. Returns are better in July and valuations seem to be driving investment activity. Will it last? Who knows, but it is fair to say that a neutral, more balanced view seems to be emerging. Neutral views mean a return to long-run returns. Better valuations are a necessary condition of that. This is what we have.
July has seen hot weather and hot markets. There has been a strong performance from growth equities, small caps and high yield bonds. Inflation and benchmark government bond returns have been flat to small up and emerging markets have underperformed, with Chinese equities displaying again diversification qualities (down while other markets are up). There has been a better tone in credit markets with more buoyant new issue activity and credit default swap (CDS) indices coming off their highs. Yet we haven’t got to the peak in inflation yet, the European Central Bank has taken its key policy rate directly from -50 basis points (bps) to zero, the Federal Reserve (Fed) is just about to raise rates again and the Q2 earnings reporting season is only just getting underway. Is it just summer lovin’?
Leave the bear
After six months or more of falling markets it may be that investors are starting to think enough is enough. They don’t want to chase the bear market further. Cash needs to be invested and a whole range of asset classes are 15% to 20% or more cheaper than they were at the start of the year. Valuations are more attractive and expectations of where the cycle goes now – while not good – have matured. The market is shifting back to a macro view that suggests a soft-landing is possible. Unemployment is low everywhere and there is the firm expectation that the very high levels of annual inflation that are printing at the moment will come down. Rate expectations have stabilised, central banks have not suggested that their terminal rate expectations need to be higher, and risk factors in credit and equity markets might well have anticipated that corporate balance sheets and cash-flows won’t be as damaged as in previous cycles.
The growth and value relationship in the equity market is interesting. Growth has outperformed this month after underperforming value since the beginning of the year. Investors choose growth stocks because they have superior earnings growth qualities, in terms of long-term growth rates and the resilience of earnings. Low debt, healthy margins, growing sales revenues and, often, technological innovation support this. They are expensive relative to the market because of these reasons. Earnings growth is either distributed to shareholders in the form of dividends or buy-backs, or more usually is re-invested to support further growth and share prices reflect that.
Growth became expensive in 2020 as rates were taken to very low levels by the Fed and other central banks. The lower discount rate boosted the present value of future earnings and the higher the growth rate, the more that boosted share prices. The opposite happened since the end of 2021 with rates going up and growth forecasts coming down. Multiple ratings on growth and quality stocks fell back to pre-COVID and, in some cases, longer-term historical averages.
In the US market, sectors like Information Technology, Consumer Services and parts of Healthcare saw their multiple ratings come down a lot in the last year. The question is whether this is a sufficient condition to increase exposure to them again. Can they grow in a world where inflation is likely to land at higher rates than before the pandemic and where interest rates will similarly be closer to levels that existed before the great financial crisis? The answer should be yes because good companies can manage in a range of macro regimes. These are sectors that have demonstrated a long history of strong and stable earnings growth – with Technology and Healthcare, particularly, displaying these characteristics. The decline in earnings amongst these companies in previous cyclical downswings has been limited.
Spending patterns will rotate again
It depends what people buy in the end. Income is being devoted to paying for higher energy and food prices, and higher debt service costs. So energy company and bank profits are high. These costs can’t keep on increasing at the current pace indefinitely, otherwise we will have a serious recession and many consumer and other businesses will face ruin. There are signs that energy prices might have peaked in the US while food commodity prices are falling. Consumer borrowing costs may not have peaked yet but will soon after market rates. At the same time, nominal incomes are growing so there will be the opportunity for some rotation back to discretionary consumer spending at some point. Consumers have not given up on replacing their cell phones or watching streamed movies and TV shows. Nor have businesses given up on further digitalization of their operations. These themes are secular and underpin the longer-term earnings story.
Momentum, don’t know it
Some investors like growth, some like value. Final investors like stocks they are familiar with – Apple, Microsoft, Netflix and so on. And markets are not efficient, which drives people crazy that argue about share prices from a pure fundamental point of view. The actual number of Apple shares in the market has actually declined in recent years, and it is the same for a number of other popular US stocks. Yet the amount of money chasing them has gone up. Thus momentum is very important - valuation premiums are long-term for these kinds of companies. When that premium comes down, these stocks look better value. Apple, Adobe, PayPal, Salesforce – to name a few – have a current estimated 12-month price-earnings ratio that is below or close to where it was in February 2020. Over that period, they have grown earnings.
I might need to take a different, more cautious view when we get the full set of second quarter results, or when there is even worse bad macro news around inflation or the energy situation in Europe. The European Central Bank (ECB), in its comments after raising rates directly from -0.5% to zero, painted a worrisome picture of the Euro Area outlook. But markets know it. Markets don’t think central banks can raise rates that much. So rate expectations have peaked. That is helping equities re-balance and credit is starting to deliver positive returns. On the other side of the coin, some of the equity sectors that have performed well have done so alongside a strong cyclical upturn in earnings that will be difficult to sustain if growth is going to be weaker. I would be surprised if the energy sector can sustain its performance while the broader industrial and materials sectors are also more at risk of earnings declines.
July has been hot. It seems markets don’t want to chase the bear case anymore. Bonds rallied after the ECB decision because weaker US data points to where the economy is heading. A cyclical slowdown is guaranteed and there seems to be more confidence in a soft landing. After 15%, 20%, 25% declines in asset classes, it may be that we are close to the bottom. It may not be a rally justified by a better macro outlook, but cash may follow the view that it isn’t getting any worse!