Equities Focus May
Summary
- 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, new wave of COVID in China).
- In April to early May, recession fears, rising bond yields & a new COVID-19 wave in China (‘zero tolerance policy’) have provoked a new correction in global equity markets.
- Equity markets now show extreme pessimism, almost pricing in a stagflation whereas we believe that global growth will prevail, with inflation peaking out soon.
- Corporate earnings to the rescue? Rapid monetary tightening is negative for equities. However, Western economies, corporate cash flows and earnings all continue to demonstrate strong resilience. In the US, Q1 2022 corporate profits have beaten expectations in 80% of the cases.
Key recommendations
Buy on weakness commodity-exposed equity markets, showing fast EPS growth, combined with lower valuations, higher dividend yield: UK, Latin America, Canada and Australia.
Favour inflation hedges, pricing power and high dividend strategies: so far, major blue chips seem capable to pass through higher input costs to end clients and even to increase their profit margins in some cases. Beware, however, those companies not capable of doing so!
Energy sector is upgraded to positive as oil prices shall remain elevated, especially now that Europe is phasing out its oil imports from Russia.
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, recession in 12-18 months?
1. Global Equities Overview
The average S&P 500, emerging market stock has held up
If rather than looking at headline stock market indices, we were to look at equal-weight versions of these indices, we would have a rather different picture. The average S&P 500 and emerging market stock has lost around 6% since November 2021.
Even the equal-weight Nasdaq 100 index shows potential signs of stabilisation.
The start of a great rotation out of Tech back into Commodities?
Leading US and Chinese tech names have continued to lead stock markets lower, while more commodity-heavy/dividend-heavy markets like the UK, Brazil and Canada have held up well over the last few months.
After the huge outperformance of technology since 2011, we may well be witnessing the early signs of a reversion back towards commodity producers.
2. Focus: Macro headwinds to stocks
Higher real yields push stock valuations lower
Of the two long-term drivers of stock prices, valuations have been the big mover, in this case lower, as real long-term interest rates have continued to rise. As long as the financial markets remain unconvinced by the US Federal Reserve’s interest rate policy, financial conditions will continue to tighten, driving both stock valuations and prices lower.
Earnings slowdown signalled by PMI surveys
The second motor for stocks is profit growth. While Q1 earnings results remain strong, both US and Eurozone manufacturing PMI surveys (and consumer confidence surveys too) point to a harder road ahead for corporate profitability. The key problems are rising input costs and wages which will inevitably weigh on profit margins, while faltering consumer demand suggests lower sales ahead.
3. Energy sector upgraded to Positive
Europe will stop all oil imports from Russia
The European Union is planning to ban all oil imports from Russia by the end of this year (although a few smaller EU countries will probably not have to stick to this deadline as they remain over-reliant on Russian oil). This shall support oil prices on international markets, as well as encourage new projects. It will also accelerate the transition towards renewable energies. European oil majors are already making good progress in building such new capabilities, whereas US oil companies will benefit from their exposure to shale oil and gas. New projects will also benefit oil service-providers in general. On top of that, the whole sector now enjoys extremely elevated refinery margins, now at unprecedented levels.
The Energy sector is particularly cheap, especially in Europe
Overall oil companies disclosed great Q1 2022 results & forecasts. They now generate huge cash flows (BNPP Exane estimates that oil majors trade at a FCF yield of 17% on average. This is very high! And P/E ratios are only at around 6). Oil majors have deleveraged and shown discipline in their new investments. They will return big amounts of cash to shareholders by increasing dividends and share buybacks. But still, this sector - whereas in much better health than it has been for a long time - is trading lower than its recent 2018 peaks, when crude oil prices were much lower (around $70 in 2018) versus more than $100 now. Momentum is very strong and we upgrade the whole sector to Positive.
4. Q1 2022 results and consensus forecasts
Good so far
Q1 2022 results have been relatively strong compared with expectations: in the US, companies have announced on average 4.5% better-than-expected profits. Regarding financials, profits are lower than last year due to exceptional factors such as very strong trading revenues and huge drops in provisions for bad loans in 2021. All sectors show positive earnings surprises, except Consumer Discretionary (Amazon). In Europe, results are also quite supportive.
Forecasts look ok & margins are holding UP well
Guidance provided by companies is also rather positive so far. Profit margins are holding up well on both sides of the Atlantic. Of course, there have been disappointments that the market sanctioned heavily (e.g. Amazon, Netflix or General Electric). It is mainly the commodity related equities that now look very solid. We thus favour relatively cheap and solid companies with a good market positioning/pricing power and not much disturbance from supply chain issues.
5. Asian Equities Overview
China: WE AWAIT more stimulus measures
• While Shanghai is still largely in a prolonged lockdown, the expanding mass testing in Beijing ignited fears of another Shanghai-style lockdown in China’s capital and weighed heavily on China assets in April.
• Efforts to suppress the spread of Omicron in China have fuelled concern over the negative impacts on economic growth and supply chains. Investor confidence has also been shaken by the government’s seemingly conflicting objectives of pursuing a zero-COVID policy, maintaining economic growth at 5.5% while not resorting to large-scale stimulus.
• The Chinese market should remain volatile until more convincing signs of a peak in Omicron infections, more decisive stimulus measures and evidence of a follow-through of previous policy pledges.
• Southeast Asian markets, such as Singapore and Indonesia, have outperformed the region YTD, thanks to the re-opening of economies. Singapore is also a good dividend play at times of heightened uncertainty over Ukraine/Russia conflicts, Fed tightening and China lockdowns.
6. 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 and supply chain issues.