#Articles — 15.07.2022

Equities Focus July

Edmund Shing, Global Chief Invesment Officer & Alain Gerard, Senior Investment Advisor, Equities

 Summary

  1. Still too early to upgrade from Neutral: too many uncertainties remain over financial conditions and liquidity, 2022/23 earnings forecasts and the path of real interest rates. The key trigger we look for is the start of a loosening in financial conditions.
  2. Decade-low sentiment not enough: investor sentiment towards stocks has reached a low point not seen since 2008. Historically, investor pessimism has preceded positive stock market returns during the following 6-12 months. But this single measure is not by itself enough to support a more positive view on stocks.
  3. Low valuations are still not enough. Stock market valuation levels are historically cheap for European, UK and Japanese stocks, while just below average for US stocks. But lower valuations are not enough to inspire a positive equities stance.
  4. Economic reality not reflected in earnings forecasts: analysts are being slow to cut earnings forecasts. To date, European earnings forecasts have fallen only slightly, and not at all in the US.

 

Key recommendations

Stay long on Energy: Oil & Gas is by far the best-performing equity sector in 2022 thus far. But we should not forget the scale of the prior underperformance of global Oil & Gas stocks against the MSCI World index since mid-2008. Oil & Gas stocks could have a lot further to run, if energy prices stay at (or above) current levels.

Dividend and buyback strategies perform strongly: these strategies are currently skewed towards high-yielding/high free cash flow  sectors such as Energy, Mining, Pharma and Financials.

Theme: Time to focus on Japanese equities. The dramatic weakness of the Japanese yen (down to levels not seen since 2007) and the very cheap valuation (< 12x forwards PE) suggest that the Nikkei has already factored in a sharp economic slowdown. This could be a great buy opportunity.

Key Risk: the risk of a technical recession (defined as two consecutive quarters of negative growth) are rising in Europe and the US, given climbing energy costs (including natural gas) and the commitment of central banks to cool inflation through interest rate hikes.

 

1. Tighter financial conditions - a key drag on stocks

Higher credit spreads, interest rates hurt stocks

In 2022, credit spreads have widened considerably both for investment grade and high yield corporate bonds. High yield credit is, in particular, very correlated to the direction of the stock market. Until we see signs of credit spreads stabilising and overall financial conditions improving, it will be difficult to have confidence in any near-term stock market rebound. US financial conditions have already tightened much more rapidly than during previous Fed hiking rate cycles.

Extreme Fear reading is a contrarian indicator

When everyone is fearful and equity funds are suffering outflows, then historically that has been a good time to invest in stocks. The CNN/Money sentiment index is showing “Extreme fear” at present. In the past, investing when this index was showing “Extreme fear” has resulted in positive returns, e.g. following the last “Extreme fear” reading in March 2020.

 

2. Bullish on Energy, dividend/buyback stocks

High dividend strategy holds up better

For the first five months of this year, US stocks and World ex US stocks (Europe, Japan and Emerging Markets) have fallen broadly in sync; both losing 17% over the year to early June. Since then, the World ex US index has started to hold up far better than US stocks, which continue to be dragged down by their growth/tech bias. Stock markets which have a large exposure to Oil & Gas (e.g. the UK and Brazil) have been key drivers of this World ex US outperformance.

Commodity-focused markets offer high yields

Note how the MSCI World High Dividend index (dividends included) has fallen only 4% since the start of the year, while US stocks have lost 17% on a similar basis including dividends.

We continue to favour high dividend and stock buyback-oriented funds and ETFs both in Europe (where yields are generally higher) and on a global basis.

 

3. Earnings forecasts

Analysts’ expectations are (TOO) OPTIMISTIC

For the calendar year 2022, expectations show an almost +10% progress in earnings in the US and no less than +14.4% in Europe. Recently, there have been downward revisions due to inflation and costs pressure. These were compensated by some upward revisions, mainly in commodities. It is very likely that 2022 expectations will need to be revised down in view of the global economic slowdown and the collapse in raw material prices (the equity market is reacting now to this sharp fall in commodity prices, see chart below).

Low visibility and economic slowdown argue for a short-term defensive bias

Visibility is low: for instance, it is difficult to predict what is going to happen in Ukraine or in China. US ‘mega-banks’ will be the first big companies to report first-half results (JP Morgan & Morgan Stanley on 14 July). Their comments and outlook will be scrutinized. In general, we believe that results should be quite resilient in healthcare, some other defensive sectors, energy and some solid technos displaying pricing power. But the situation seems to be getting worse for cyclicals. Therefore, this summer, keep a defensive bias!

 

4. Asian Equities view

Chinese shares rebound on EASING covid restrictions and potential stimulus

•  China is gradually easing its COVID restrictions, having controlled recent outbreaks. It has also relaxed rules on its quarantine policy for international arrivals. We recommend playing China via A-shares as they are domestically-driven (tend to be less impacted by the volatile global equity market) and onshore investor sentiment has been improving.

• There is more encouraging news on the regulatory front for China’s internet sector and we think the worst is over. That said, there is no regulatory loosening, and the “good old days” of very high profit growth of platform companies are unlikely to return. There could be some near-term profit-taking pressure after the sector’s rebound in June.

• We are looking to upgrade offshore Chinese equities when global market stabilises and/or when we see more clarity in the political and policy direction after China’s 20th Party Congress (taking place in the autumn with announcements of major leadership changes).

• Other Asian equities suffered in June, impacted by the negative sentiment on growth concerns,  due to the faster-than-expected monetary policy tightening globally to counter inflation. We continue to recommend defensive plays and remain overweight on Singapore equities due to their high dividend nature.

 

5. Sector Allocation

In these uncertain times, favour defensive sectors but stay hedged against high inflation

Recent economic data have upset the market, particularly the inflation figures, still higher than expected in the US and in Europe, whereas the PMI data (business confidence indicators) were lower than anticipated. The market has concluded that there could be more monetary tightening than expected, with 10y T-Bond yields reaching new highs not seen since 2011 in the US!

- Despite the economy cooling down, the probability of a deep and lasting recession is still low considering the healthy balance sheets of corporates and consumers. But we do not deny that inflation decreases their purchasing power and undermines confidence.

- Due to soaring inflation and bond yields, June was a very challenging month. All sectors ended the month in the red with defensive sectors outperforming. Healthcare was the best-performer with -2.5% and European Basic materials were the worst with -19%! Even the star performer this year, Energy, collapsed -15% in June.

 

In this environment, investors should keep large positions in sectors doing well in inflation times, particularly Energy, Metals and Mining. Financials also tend to benefit from steepening yield curves, especially this sector is very cheap (preference now for insurers and diversified financials, considering the economic slowdown affecting banks relatively more).

Earnings revisions still favour the above discounted sectors, making them appear even cheaper.

European REITs also trade at bargain prices, after a collapse this year, due to bond yields rising sharply.

- On the other hand, companies with pricing power and/or distributing high dividends are outperforming.  They should represent a large slice of any portfolio.

-  In the short term, we are cautious  about Cyclicals closely correlated to the global economy: Industrials, some Materials & Consumer discretionary.

- On the other hand, we expect a rebound in Growth sectors which have fallen too much and/or which now look quite cheap (i.e. Semi-conductors, E-gaming, Luxury, Health care).

 

7. Investment ideas

Growth stocks tradE at cheap valuations

Equity markets collapsed in H1 2022. The main victims were the Technology sector (admittedly quite expensive at the beginning of the year) but also other growth sectors such as Luxury (& some other Consumer Discretionary segments), Communication Services, Med tech, etc. Some of these industries boast strong pricing power with order books quite full. Valuations now look very attractive, especially in Semiconductors.

We like healthcare. Is Biotech set to recover?

Cyclical growth industries may need time to rebound. Investors prefer to stay defensive at the moment. If inflation were to peak, Biotech would offer good potential. Remember also that the Healthcare sector remains a favourite due to good earnings expectations and very reasonable valuations (see IBES forecasts in the Appendix). Bank of America notices the beginning of a “Big rotation from inflation to deflation assets’.