WHAT HAPPENED AND HOW DO WE MAKE SENSE OF THIS?
Obviously, one cannot deny that the Russian invasion has accelerated predeveloping inflationary pressures (mining, fertilisers, supply chains to name a few) and that European growth in particular is highly dependent on Russian gas supply. In addition, confidence among economic agents has been impacted and a logical GDP deceleration (from a relatively high starting point) should be expected later this year. Furthermore, monetary tightening in most places will, on top of supply chain disruption, commodities and upcoming inflationary labour pressures, contribute to a squeeze of corporate profitability and put downwards pressure on demand over coming quarters. Negative earnings revisions on the cyclical end of the market should follow at some point. Note though that these are far from obvious as of today (with robust earnings confirmed in early days of Q1 reporting season), even when excluding the very favourable commodity sector’s contribution to European indices.
But even with low macro visibility and rising headwinds for the market (and cyclical stocks in particular), the best opportunities always present themselves at a time of maximum uncertainty (remember March 2009 & 2020). This requires a careful analysis of fundamental risks (with balance sheet and cash generation resiliency being front and centre in times of stress) has been implemented beforehand. While a European macro slowdown looks plausible, a recession in Europe in the short term seems rather unlikely, as long as tail risks don’t materialise (think of gas rationing in Europe becoming the base case scenario, though European gas prices are now nearly back to pre-invasion levels). However, valuations close to their historic troughs in some value industrial/material names seem to already price in a rather gloomy outlook/mild recession. This makes for an interesting asymmetry.
Rather than trying to call the economic outlook, the high dividend/value stock picker should instead revisit and validate the fundamentals of cyclical companies trading close to their trough valuation and pricing in a gloomy earnings outlook. Purpose of the exercise is to ensure that, in most scenarios, dividend capacity will be preserved. In this regard, there is good news: Starting from a position with healthy corporate balance sheets and margins on top of reasonable pay-out ratios, a decent number of picks in this cyclical value end of European (high) dividend picks look well-equipped to deal with a range of difficult scenarios.
In summary, markets dislike uncertainty and are prone to quickly go from one valuation excess to another. However, attractive valuation alone is not enough for an investment case to work. While we clearly do not encourage investors to make (or time) a top-down macro call, we do believe that a valuation-disciplined stock picking approach can point to interesting medium-term risk-reward or upside asymmetry, especially for market segments that have been heavily impacted by peak uncertainty.
