Investment Strategy Focus: December 2022
Going for Gold
1. Upgrade to Buy on stocks: look through a temporary dip to recovery beyond. Key drivers include falling US inflation, lower long-term interest rates, improving macro liquidity, and easing energy prices. Build stock exposure gradually, use short-term market consolidations to add, favour value and world ex US over US.
2. Positive on cyclical sectors – Mining, Banks. Mining should benefit from rebounding Chinese activity, low base metals inventories. European banks should benefit from surprisingly resilient consumption, a rising ECB deposit rate and solid capital ratios. Both Mining and Banks remain cheap versus long-term average P/E and price/book value ratios, offer generous dividends.
3. Global liquidity starts to rebound: in 2022, unusually, global money supply has shrunk as central banks remove emergency COVID-related stimulus – weighing on financial markets. Since October, the global money supply has begun to rebound, led by the People’s Bank of China.
4. November the peak in European inflation? While US inflation is steadily declining, Europe has lagged due to the impact of record energy prices and supply chain disruption. The worst of these inflation effects may now be behind us. Favour shorter-term sovereign bonds, US and Euro investment-grade credit exposures.
5.Focus on: Gold begins to glitter again. Thanks to lower real yields and a weaker US dollar; gold should still be considered as a useful diversification asset in investors' portfolios. Dynamic investors could consider exposure to a broad basket of precious metals, including silver and platinum.
Why Positive on Stocks today?
The key indicators behind our stocks upgrade
1.(Lower) inflation rates, peaking central bank rates: we expect US inflation to fall rapidly in the coming months, on the back of moderating demand, easing supply chain pressures, a weaker housing market and lower fuel prices. We also see easing labour market pressures, as the corporate focus turns to reducing staff rather than adding.
2.Falling energy price pressures: the single biggest element of European inflation is painfully high natural gas, electricity, and diesel prices. These prices have all eased substantially since the August peak, while LNG imports from the US continue to increase. Adapting industrial and consumer energy demand should also help lower price pressures ahead – the cure for high prices is high prices.
3.(Lower) Real bond yields: 10-year bond yields have fallen 0.6%-1.0% since the October peak, pushing down real yields. These lower real rates support equity & corporate credit valuations - reversing the situation since January, when rising long-term rates lowered fair market stock valuations.
4.(Looser) Financial conditions (credit spreads, volatility, interest rate spreads): lower US and European investment-grade credit spreads, lower stock market volatility, improved global liquidity all contribute to looser financial conditions in the US and Europe compared with the mid-October peak in financial conditions.
5.(Rebound in) Economic momentum: near-term economic momentum continues to improve in the US, UK, and Europe. Further improvement could highlight that these expected periods of economic contraction could be shallow and relatively short-lived, allowing investors to “look through” the bad news to better times ahead.
6.(Weaker) US dollar index: since the September peak, the Bloomberg US dollar index has fallen over 6%, breaking its prevailing uptrend in place since May 2021. Lower safe-haven demand, a peak in Fed funds rate approaching quickly and easing pressure on the euro from lower gas & oil prices are the main drivers of this lower US dollar. We expect an even weaker US dollar over the next 12 months.
Multiple indicators underlie our upgrade of Stocks to Positive, including real yields, financial conditions, liquidity and cheap prevailing valuations for many segments of the global stock market. We watch and expect major stock market indices to remain above their own 200-day averages to confirm the recent positive trend, and remain watchful for potential black swans that could derail this improving momentum.
What stock exposure to favour
Build up exposure to stocks gradually
Positive on Stocks on a 12-month investment horizon. We expect stock markets to follow a bumpy, but higher, path over the next 12 months on the back of more favourable inflation, long-term rates, financial conditions and the US dollar environment.
Increase stock weights gradually: volatility is likely to remain elevated given persistent geopolitical and economic uncertainties. So we would advise a gradual increase in stock weightings in investor portfolios, taking advantage of any short-term consolidation or correction in stock markets to add exposure.
Investors who are able, can also consider taking additional long-term exposure to stocks via equity-based structured solutions, benefiting from today’s volatility and more favourable financing conditions.
Prefer ex-US regions to the US: since mid-2008, US stocks have beaten the stocks in the Rest of the World, by a wide margin. This was driven by outperformance of technology-related growth stocks and of the US dollar. Since October, this trend has started to reverse, with the value factor beating growth. World ex-US valuations trade today at a record discount to US stocks, suggesting future long-term outperformance.
Sectors: Upgrading Mining, Banks to Positive: to reinforce our preference for value-oriented and economically cyclical industries, we also upgrade the Mining and Banks sectors to a Positive stance. Both sectors (particularly in Europe):
1.Remain very cheap on P/E and Price/Book value relative to long-term average,
2.Offer high dividend yields (7% for Mining, 6.5% for Banks) backed by generous cash flow yields,
3.Maintain very solid balance sheets, and
4.Should benefit from a rebounding Chinese credit impulse and higher ECB deposit rates respectively.
Positive globally on the value factor: buoyed by moderate economic growth, expanding profit margins and ultra-low interest rates, growth stocks posted 118% outperformance versus value stocks from 2007 to August 2021. Since then, value has rebounded vs. growth by 32%. But given the scale of the rebound of value against growth from 2000 to 2002, and from 2003 to 2007, we believe value may have a lot further to run. Favour sectors, funds and ETFs focused on value stocks, including higher dividend strategies.
Upgrading cyclical sector exposure – Positive on Mining, Banks, to add to existing positive views on Energy and Insurance. Mining should benefit from the rebounding optimism over Chinese activity and low existing stocks of key base metals, while European banks should benefit from surprisingly resilient consumption, a rising ECB deposit rate and solid Tier 1 capital ratios. Both Mining and Banks remain attractively valued versus long-term historical average P/E and price/book value ratios.
Tilt towards value sectors, US mid-cap
Within our positive stance on global stocks, there are a number of clear trends and preferences that we would highlight for investors looking to gradually deploy cash back into stocks after a tough 2022 to date.
Stay the course with Energy: we believe that energy prices have an asymmetrical outlook – a much higher probability that they rise than fall over time, remaining far above long-term averages. We favour the global Oil & Gas and Renewable Energy sectors.
Cash flow-rich value sectors still favoured: we like portfolios based on the value style, containing a heavy bias to strong cash flows and balance sheets, given the inherent Energy, Financials and Materials sector bias.
Prefer US mid-caps over large-caps: US mid-caps are much more domestically-focused than large-caps, which is a definite advantage at the moment given the strong US dollar (and the impact on overseas earnings of US large-caps), while US domestic consumption remains strong. US mid-caps still boast robust balance sheets and trade currently at a historically wide 25% P/E discount to the S&P 500 index.
Japan is still worth a look
Japanese equities offer increasing quality & value: over the year to date, hedged exposure to Japanese stocks via exposure to the Wisdomtree Japan hedged equity index would have generated a +2/+3% return in euros or US dollars. Post a 23% slide in the trade-weighted Japanese yen index since the start of 2021, Japanese exporters today have a huge competitive advantage to exploit. Japanese stocks look cheap on a (12x) P/E, (2.9%) dividend yield and (1.2x) price/book basis. This suggests the potential for higher long-term returns from Japanese stocks.
Peak US dollar to drive World ex-US comeback? A stronger US dollar and a technology stock mania in the late 1990s were the twin motors of US stock outperformance up until 2000. Today, we have seen the same tech mania and US dollar strength trends, notably since 2020. But a peak in the greenback plus unwinding of tech stock outperformance could drive World ex-US outperformance, as seen in the 2003-07 period. The starting point is a record gap in valuations between US stocks and the World ex-US stock universe.
There are continued signs of improved trends in bond yields, financial conditions, liquidity, and near-term economic momentum. These trends are key factors in our upgrade to a Positive stance on Stocks, even given the latest rebound. We retain a bias towards the value investment style, towards energy sectors, Japanese and UK stocks and to US mid-/small-cap exposure. More conservative investors can focus on quality dividend strategies given the generous pay-outs available today, especially ex-US.
Focus on China: China Reopening?
The twin triggers of: i) stabilising the Property Market and ii) loosening of COVID restrictions are the key catalysts for China Equities. Higher vaccination rates are key to the reopening in China over the winter months, given the high transmissibility of the Omicron variant and the ineffectiveness of COVID controls.
While more than 90% of China’s population is fully vaccinated, the numbers decline with age, with the figure dropping significantly for people over the age of 80. Only 65.8% of people over the age of 80 are fully vaccinated and just 40% have received their booster shots. The vaccination rate for this particular group needs to go up.
Therefore, recent actions in the past few weeks are increasingly encouraging. Beijing’s National Health Commission stated that they would “accelerate the increase in the vaccination rate for people over the age of 80, and continue to increase the vaccination rate for people aged 60-79”, adding it would “establish a special working group…to make special arrangements for the vaccination of the elderly against COVID”.
There is also a strong likelihood that restrictions will be increasingly targeted, as China moves away from excessive COVID curbs, mass testing and lockdowns.
Major urban areas, such as Shanghai and Hangzhou, are loosening restrictions. This is an important signalling effect from regional governments. Apart from the gradual change in tone on their COVID-19 stance since the October party congress, the property market continues to be an ongoing focus. There seems to be a new lease of life in the property sector, aided by reserve rate cuts and funding support for local developers, illustrated by the CSRC (China Securities Regulatory Commission) statement of five measures to assist in equity finance. We have upgraded our medium-term allocation to overweight on China equities, as we believe most negatives have been priced in and further significant downside may be limited. Shifts in major policy stance (COVID & property) are encouraging but early in the process, while progress in vaccination will be crucial for the latest rally to translate into a full recovery. We don’t believe there will be a large, one-off ending of COVID containment or an instant reopening. A gradual, calibrated re-opening could occur potentially begin in spring-summer 2023 if the COVID situation improves. Despite the recent rally, valuations remains very attractive and are not priced for this outcome. There could still be near term volatility, but any of such volatility can be viewed as an opportunity, particularly for policy beneficiaries.
• We upgrade our recommendation for global portfolios to overweight on China Equities. The recent sharp rebound in the Chinese credit impulse is a key leading indicator for the Chinese economy and for financial assets.
• The twin catalysts of a gradual reopening and an eventual bottom in the property sector are likely in the next six months. Moreover, valuations remain attractive.
Focus: Gold to glitter anew?
Gold has protected non USD-investors
Gold has been a positive asset class for euro, sterling, Chinese renminbi and Japanese yen investors – euro-based investors have seen a 6% gain so far this year.
However, the gold price in US dollars has been held back since January by two major factors:
a. the stronger US dollar on the one hand, and
b. higher long-term bond yields on the other.
Why then is gold interesting for investors today? We see four main reasons:
1.The US dollar is now weakening, boosting opposing currencies including financial commodities such as gold;
2.Lower long-term US bond yields and thus lower real yields (after subtracting expected inflation);
3.Real diversification, after a year when bonds have NOT been an effective diversifying asset, and
4.When the claim that bitcoin is a true digital store of value (thus competing with gold) has been heavily undermined by its 75% drop from the November 2021 peak.
Central bank gold purchases accelerate
There are two other noteworthy points regarding gold:
1.Central banks have been heavy buyers of gold all year long, as Russia, India and Chinese central banks look to hold more reserves in assets and currencies other than the US dollar and US Treasury bonds.
In my view, this trend is likely to continue, as the US dollar becomes less and less attractive to these countries now that the US has effectively "weaponised" the US dollar.
2. Since the beginning of 2000, gold has outperformed other asset classes by a wide margin at +422% (in USD) to date, versus +209% for global stocks, +369% for global listed real estate and +111% for global sovereign bonds and credit.
Ultimately, the combination of ongoing geopolitical tensions, lower bond yields and a weaker US dollar all remain favourable tailwinds for both gold, and by extension other precious metals, such as silver and platinum.
Gold is starting to glitter again, and should be considered as a useful diversification asset for investors' portfolios. Those with a higher risk appetite could also consider exposure to a broad basket of precious metals, including silver and platinum, which in many ways look fundamentally even more attractive than gold given the rising demand from energy transition applications (e.g. solar panels, hydrogen power).
The Macro Picture
Do we underestimate our ability to adapt?
US inflation continues to cool: the personal consumption expenditures price index (PCE), tracked closely by the Federal Reserve, rose by a below-forecast 0.2% for the month of November. This continues the trend of easing US inflation pressures and arguing that higher interest rates are cooling demand and thus also inflation.
Key goods-related components of US inflation are headed lower, as underlined by the sharp falls in the US ISM manufacturing prices paid sub index. This has fallen from an extremely high 87 reading in March (on a 0 – 100 scale, where 50 is flat) to a contractionary 43 as of November.
To this we can add falling rent inflation, lower gasoline prices and global food inflation that has fallen from 30% year-on-year in March to under 2% in October, according to the UN’s Food & Agriculture Organisation.
A modestly stronger euro should help calm euro inflation: there is also initial evidence of a November peak in eurozone inflation, aided by similar supply chain-related factors to the US. The inflationary hit from energy prices will moderate quickly in the months ahead, and a stronger euro will also help to moderate import prices.
Consumption is supported by excess savings: US households have spent one-third of their excess lockdown cash savings, supporting retail sales. European retail sales have similarly held up well, with consumers still sitting on historically high cash savings. This cushions economic slowdown, with employment levels high and salaries rising.
Our impressive adaptability when faced with a crisis: one response to sharply higher prices is a change in behaviour. When energy prices surge and stay high for long enough, we find ways to save energy to offset this higher cost. When prices of certain food products rise sharply, we move to substitute foods which are cheaper.
When looking at standard consumer inflation baskets, remember that these baskets do not capture these price-linked changes in buying behaviour in a timely fashion. I would argue then that inflation baskets often over-report surges in prices, as this shift in purchasing choices is not captured. These are good reasons then to expect economic weakness in the near term, but not a deep drop in demand. Rather, we see an adaptation of the make-up of consumer demand from expensive products and services towards cheaper alternatives.
While US inflation is already steadily declining, Europe has lagged due to the pass-through of record energy prices and supply chain disruption. The worst of these inflation effects may finally be behind us, with a stronger euro to help calm import price pressures. Post a Fed tightening of monetary policy to a level equivalent to the 2007-08 peak, expect a peak US Fed Funds rate of 5% in January, 2.75% for the ECB’s repo rate by March.
10-year sovereign yields compress rapidly
10-year US, UK Treasury bond recommendations have worked well: government 10-year bond yields peaked in mid-/late- October on a global basis.
Since then, the rally on the back of peaking inflation has seen a 1.4% compression in UK 10-year gilt yields from a 4.5% peak to 3.1% today (plus sterling appreciation for non-GBP investors). Italian 10-year BTP yields have fallen over 1% to 3.3% now, while US 10-year Treasury yields have reduced by 0.7% to 3.5%.
Our positive recommendations on both UK and US government bonds have worked well: from the lows, UK 10-year gilts have returned 11% in under 2 months, and 7% for US 10-year Treasuries.
In sovereign bonds, favour shorter maturities: however, the fall in 2-year government bond yields has been more limited. Indeed, 2-year bond yields remain far higher than long-term yields (“inverted” yield curves), and thus offer higher income returns at lower risk today. A 2.5% yield is available in Italian 2-year BTPs, and 4.2% in 2-year US Treasuries.
Modest gains in IG credit, yields still appeal: we retain our positive recommendation on investment grade (IG) credit as an asset class, even after a 4% gain in Euro area IG credit and a 7% return in US IG corporate bonds since late October.
Even after this rebound, the average BBB-rated US corporate bond yield today sits close to decade-highs at 5.8% according to Moody’s. European BBB-rated credit offers a 4.1% yield, close to the highest yields since 2012.
A terrible 2022 augurs better for credit in 2023: 2022 is by far the worst year on record for US IG credit returns (over the past 50 years). In total, 11 years out of the past 50 have seen negative IG credit returns, but only 3 worse than -3% before 2022.
If we look at the 6 previous years where US IG credit returns were -2% or worse, in 5 cases the subsequent year’s corporate bond returns were strong. The only exception was 1979, with a tiny drop again in 1980. This augurs well for US IG credit returns in 2023.
Falling US Treasury bond volatility reinforces our Positive view on IG credit (offering around 5.8% for BBB-rated bonds in the US, and 4.1% in Europe). This view is comforted by the decline in investment-grade credit risk (measured by CDS spreads) the relatively solid balance sheets and the cash flow generation of companies in the IG credit universe. In contrast, we maintain our caution on High Yield credit, given rising risks to “zombie” companies that may struggle to secure debt refinancing.