Equities Focus June

Summary

1. Neutral overall: we remain neutral overall on Equities as an asset class (including in Europe, Emerging Markets), as we await further potential reduction in uncertainties (inflation, rising bond yields, monetary policies, war in Ukraine, energy crisis).
2. Positive signs for equities include: falling credit spreads, falling real bond yields, less financial market volatility, extreme investor pessimism.
3. Bear market rally, or a more durable rebound? Stock markets have started to rebound from mid-May lows despite clear signs of slowing economic growth. Is this merely a bear market rally or a more lasting rebound? The answer depends on the risk of a recession. If this is a recession scare, as we think it is, then a rebound may endure.
4. Earnings upgrades v downgrades: commodity-related sectors enjoy the strongest upgrades to earnings forecasts in Europe and the US. Consumer discretionary and industrial sectors are most at risk of downgrades from rising costs & weaker demand.

Key recommendations

Stay long Oil & Gas: Oil & Gas is by far the best-performing equity sector in 2022 thus far. But remember 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 sectors such as Oil & Gas, Mining and Banks. European banks have been surprisingly robust performers of late, on the back of above-consensus results.

Circular Economy theme in focus: very high energy and raw materials prices underline the need to optimise our use of natural resources – the focus of the circular economy model.

Key Risk: US Federal Reserve tightening too hard in an already-slowing economy? 3% Fed fund rate is now priced in for 2023. We have our doubts. We think the Fed is likely to soften their discourse in the coming months. If not, a recession in 12-18 months?

1. Just a bear market rally, or real stock rally?

Previous bear markets saw strong rallies

During the long bear markets of 2007-09, 2000-03 and the Japanese bear market in the early 1990s, there were several moments when stock markets rebounded by over 10%. Is the 7% rise in the US S&P 500 and Nasdaq indices and the 8% rise in the Euro STOXX 50 from mid-May lows the beginning of a sustainable stock market recovery, or just one of those bear market rallies that could soon run out of steam?

US Financial conditions begin to ease

A key drag on stocks has been the sharp tightening in US financial conditions. This means that financing has become more difficult and more expensive for both companies and households. Note how US financial conditions have finally started to loosen, with lower bond yields, tighter credit spreads and falling stock market volatility. The continuation of these trends should help stocks.

2. Falling credit spreads good for stocks

Risk rally extends to the credit market too

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. Note how credit spreads have stopped rising, and are now starting to fall as credit finally becomes more attractive to bond investors. This is a positive sign that the risk rally we have started to see in stocks is extending to other key risk asset markets, such as credit, too.

Extreme Fear reading is a contrarian indicator

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

3. Still bullish on Oil & Gas, dividend stocks

World ex-US starts to beat us stocks

For the first four months of this year, US stocks and World ex-US stocks (Europe, Japan and Emerging Markets) fell broadly in line with one another; both losing 15% over the year to early May. But in May, World ex-US started to hold up far better than US stocks, which continue to be dragged down by the US index’s growth/tech bias. Stock markets heavy in oil & gas exposure like 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. In regional terms, commodity-heavy UK and Brazilian markets offer higher yields.

4. Water – precious in design

A key input for growing food and economic activity

Population growth and economic development are driving a sharp increase in water demand. Billions more people expect to have regular showers and eat more water-intensive food. At the same time, climate change and shifting weather patterns are making the distribution of rainfall less predictable. This contributes to increased water stress at a global level. Addressing these issues will require significant capital investments in new technologies and services.

A defensive approach to ESG – Investing

Compared with more growth-oriented and thus more volatile ESG themes, water offers a low volatility, value-oriented approach. Most water-related indices include a high degree of utilities, which often offer attractive dividend yields and are less influenced by the economic cycle. Those characteristics helped the theme to accumulate an outperformance of ca 70% during the last decade.

5. Asian Equities view

China: COVID RESTRICTIONs are easing, stimulus incoming

• China is moving towards relaxing COVID restrictions in Beijing and Shanghai, after local authorities confirmed that the outbreak was now under control. This includes reopening of businesses, shopping areas and most public transport as the number of infections fell to their lowest since early March. The local Shanghai government also rolled out targeted measures to support the lockdown-hit economy, including restarting of manufacturing on 1 June.
• Activity in both China’s manufacturing and services sector ‘rebounded’ in May, but recovery remains ‘tepid’. The official manufacturing PMI rose to 49.6, from 47.4 in April, while the non-manufacturing PMI rose to 47.8 in May from 41.9 in April.
• The Chinese market remains volatile given the policy uncertainties and the long-standing zero-COVID policy. More decisive stimulus measures and evidence are required to follow through on previous policy pledges. Nonetheless, signs of slowing coronavirus infections are helping to reverse negative sentiment.
• Asian equities outperformed most regions, as the reopening of this region buffered the ongoing uncertainty surrounding the Ukraine/Russia conflict, Fed tightening and China lockdowns. We remain overweight Singapore on reopening, and Indonesia on commodities exposure, with both countries still up year-to-date.

6. Focus on Brazil

Bullish on Brazil on commodities exposure

There are good reasons to be bullish on Brazilian stock and bond exposure in spite of currency volatility and high inflation rates (12% at the current time).

Firstly, inflation is high in most of the developed world! So Brazil is not alone in this. Secondly, historic long-term returns have been strong since 2001 for stocks and 2003 for sovereign bonds, even when denominated in euros or US dollars. Since 2003, Brazilian sovereign bonds have delivered an average annual 9.7% total return in US dollars, thanks to the historic high yields that Brazilian sovereign bonds have offered in hard currency (USD).  Today, one can still enjoy a 5.5% yield in US dollars from a Brazilian 10-year sovereign bond, still 2.6% above an equivalent US Treasury or Chinese USD sovereign bond.

Brazilian equities have similarly performed well, beating the MSCI World in common currency terms since 2001. However, this outperformance has come in concentrated bursts, typically when commodity prices are enjoying a bull market phase (1999-2000, 2002-2008, 2016-18, 2020-). Note how Brazilian equity performance has diverged from overall MSCI Emerging Market index performance since 2021, with the divergence between Chinese technology stocks and Brazilian energy and mining stock performance.

If we can avoid a global recession in 2023, elevated commodity prices for energy, metals and foodstuffs suggest further upside for the Brazilian stock market. Bear in mind the low P/E, and a dividend yield well in excess of 8% backed by huge commodity-related cash flows. Yes GDP growth is forecast to be in the 1-2% range for 2022 and 2023, but with CPI due to fall rapidly over the next two years, this is a support for sovereign bonds, while global commodities demand remains the dominant driver for equities.

7. Sector Allocation

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

Energy sector is upgraded to positive after the recent consolidation.

Due to persisting uncertainties, we recommend staying relatively prudent and well diversified. Inflation figures remain very high, bond yields are rising and it is unclear if and when central banks will stop tightening. However, risks seem much better priced in now compared with the beginning of this year.

• The global economy is cooling down and many investors are increasingly nervous given the flattening/inversion of the yield curve. And now China is also cooling down. We do not foresee a recession in 2022, but we believe in staying somewhat more defensive in the short term. Our favourite defensive sector, Health Care, has been the best sector in Europe since Russia invaded Ukraine: +10% (24/02 until 25/04) against +1.4% for Stoxx Europe.
• Other defensive areas in the market, such as high dividend strategies, have also outperformed.
• The worst-performing sectors since 24/2 are retail, autos, banks, travel & leisure, etc.

Energy security has become a major issue in Europe, often criticised for ‘financing the war in Ukraine’. Europe is looking for alternatives to Russian oil & gas. This is another supporting factor for Western oil & gas companies. The sector is very cheap, it has published great results, and generates huge cash flows, allowing for new investments, fat dividends and share buybacks. We upgrade Energy to Positive.

• This year, we have been strongly advocating portfolio hedges against inflation, with the following as the main beneficiaries: commodities, European real estate, but also some select US real estate and some financials (our preference is now for insurers and diversified financials).
• Earnings revisions also support these sectors.
•  Companies with pricing power have also posted a much better performance and should take a larger place in any portfolio.
•  In the short term, we would be cautious of sectors exposed to China (industrials, materials, some cons. discretionary) due to the economic slowdown there.