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With its short memory and bouts of volatility, the equity market remains fertile ground for the high dividend and valuation-focused stock picker.
In January, the consensus narrative was that the European growth outlook was better than it had been in a while: Unemployment rates were remarkably low, the corporate sector was ready to accelerate its capex and public authority policies were generally supportive at EU level, the latter with a focus on digital and climate change fronts. At the same time, the end to most COVID measures in the West and consumers’ accumulated savings were expected to cause a sudden release of pent-up demand across service sectors. Also, a continued rebalancing between monetary (where a gradual normalisation of policy was expected) and fiscal measures among policymakers was supposed to be instrumental in fighting inequalities. Overall, this pointed to a cocktail which should have given incremental impetus to the value/cyclical end of the equity market. Against that backdrop, and rather unsurprisingly, a large value value/cyclical rotation had taken place by the end of February.
A few weeks later, following both Russia’s invasion of Ukraine, and various hawkish monetary communications and actions from central banks, what do equity market internals tell us?
The pharmaceutical sector performance is generally the most negatively correlated with new ISM orders and is often seen as the gauge for market stress. After a strong run, this sector‘s valuation has reached a record premium vs European market. From what we can see, improving fundamentals of individual pharma companies and cheap valuations have been present for a while. However, it was a confluence of external macro events that caused the sector’s recent rerating.
EU large caps pharmaceuticals absolute and relative valuation vs EU market
European sectors correlation with ISM New Orders
Source: Credit Suisse
On the other hand, most value cyclical stocks (except for commodities) have corrected meaningfully, with some stocks even trading close to COVID lows. Among others, some companies’ valuations on the “value” end of the industrial sector have corrected close to their historic trough, disregarding both the structurally improved business mix (thanks to higher contributions from margin-enhancing and recurring-service components instead of lower-margin and more-volatile equipment revenues) and revenue tailwinds from digitalisation or climate-change capex trends. Overall, the performance of European non-financial cyclicals is consistent with ISM new orders in mild recession territory (mid 40s – see graph below). Finally, as confirmed by the dividend futures markets, some institutional end-investors are starting to question the sustainability of dividend payment projections of companies listed on the European market.
European cyclicals (ex-financials and ex-technology) relative performance to defensives versus PMI manufacturing new orders
Source: Credit Suisse
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.