Inflation is definitely a key factor to consider. While it seems that headline inflation has peaked, the rate at which it comes down and how far above the targeted 2% level it lands will be important. Structurally higher inflation has consequences for debt repayment, the cost of capital, and comes with several investment hurdles.
Valuation is also a major factor in investment decisions. Global equities have generally come down significantly this year due to changes in central bank policies and geopolitical risks. While markets were considered a good deal a month ago, the recent rally has pushed valuations back to pre-crisis levels. In the US, the market is now priced at 17x earnings, the same level as in 2019. However, inflation has risen above 8%, interest rates have been raised four times, and GDP growth has slumped. This pricing assumes no recession, or at least a soft landing. However, there are signs of weakness, with 30% of S&P 1500 stocks priced at less than 10x earnings. In Europe, valuations are extremely cheap due to the ongoing Russia/Ukraine war and energy crisis. This has caused foreign investors to seek safer places like the US. Is this a buying opportunity? Probably, but not definitely.
Liquidity is another factor to consider. After a decade of plenty and relatively calm markets, central banks’ tough stance on controlling inflation has been accompanied by more volatility. And more volatility usually means less liquidity. The depth-to-book ratio shows that almost no deals are being done at listed bid/ask levels, which makes sense given the extreme volatility. A recent analysis by the IMF also shows that measures of market liquidity have gotten worse across asset classes in recent weeks. This is, of course, a big challenge for valuations.
We already talked about performance when discussing valuation. To better understand the causes of price drops, we tried to break down the year-to-date return to get more insight into the nature of the price declines. The outcome shows that the derating was entirely due to multiple compression (i.e., derating due to increasing real yields used for discounting future cash flows) and not because of weakening earnings. In fact, it shows that in the US, earnings growth is still strong at 5%+ and more than 20% in Europe! And dividends are still solid because of the strong cash flow-generating ability of the corporate sector. Earnings that remain solid are the tricky part of the story. Central banks are supposed to fight inflation and will impact spending. If spending goes down, demand goes down, and companies will see earnings go down too. To maintain high margins, they will need to rely on improving productivity or cutting costs (read: laying off workers). Analysts have become more conservative, but only slightly so far. In past downturns, forward earnings fell much more than we have seen today. In USD terms, consensus EPS growth has only been reduced by 5.6% for the US and 5.2% in Europe. This means that earnings growth next year is still in positive territory. The change in consensus EPS has only moved down 6.5% for the US and 2.1% for Europe. We believe that current expectations of avoiding an earnings decline next year are too optimistic because margins are at an all-time high and PMIs are in contraction mode. This will likely keep stocks under pressure even if interest rates stop rising.
In local currency terms, EPS has gone up 8% for Europe year to date, while for the US, EPS has gone down 4%. Surprisingly, earnings growth for next year has only gone back to 0.7% in Europe and 6% in the US. The difference in the nominal figures for Europe is mainly because of the currency factor – the USD has gone up a lot since the start of the crisis – and also because of inflation. Analysts aren’t used to extremely high inflation figures and don’t know how to deal with it. Today, the market does not anticipate a harsh recession. GDP growth is still estimated to stay the same next year. If GDP were to go down 1-2%, then EPS growth might go down 10%.
When we look at the earnings revisions at the style level, we’re surprised to see that negative earnings revisions have mainly happened in the Growth style and right from the start of the crisis, while in the Quality style it only started this summer. The Value and Low Risk styles have stayed almost the same so far.
Equity flows are also a good indicator of whether investors are more confident about turning back to risky assets. This isn’t the case yet. Investors are still scared of equity markets and continue to go to safer assets or safer regions like the US, where economic growth will be less affected than in Europe. In the US, we see people continuing to switch from active funds to ETFs, but this isn’t happening in Europe.
There’s a saying that investors need to show signs of giving up before they can start taking more risks with their portfolios. There’s evidence that retail investors are always late to the party and tend to buy when markets are near their peak and sell when they’re at their lowest. Today, institutional investors are being careful and not investing in risky assets like equity and credit. But retail clients are still more than 60% invested in equities, according to the latest Bofa Global Investment Report.
Based on what we’ve analysed, we can conclude that a long-term decline in core inflation is the most important thing to watch for. Earnings and liquidity are hard to rely on, investor sentiment is very weak but not yet extreme, and equity derating still assumes that things won’t get too bad. We’re dealing with a one-trade market: inflation is the key. The bottom of inflation will probably happen when interest rates go up too much. It’s very hard to predict exactly when that will be.
Concretely, what does all of this mean? Should we wait for the tide to turn and disregard this asset class in the meanwhile? Not quite. In fact, every crisis brings opportunities, and the following segments have been hit particularly hard:
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- One opportunity is China, which could be a wild card for next year. China’s economy is still a big part of global growth, and as the government keeps its zero covid policy, there are signs of things easing up on the ground (airlines, migrant labor, etc.). The new 16-point plan is also trying to restructure the real estate sector and restore confidence. In the meantime, foreign investors have given up, and the market is very cheaply valued at only 11x P/E. When investing in China, you need to be very selective and focus on firms with strong fundamentals. Challenges will remain, but there is potential for outperformance. Taiwan will remain a problem, but Xi Jinping and Biden are trying to improve relations.
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- Another opportunity is Asia ex China, which offers a wealth of opportunity. India is a powerhouse on its own, with expectations to capture 15% of world GDP by 2050, close to China’s expected 20%. The region trades only at 13x P/E compared to 17x for the US, which offers lower growth. Vietnam, the Philippines, and Nigeria are expected to grow 4%+ annually until 2050. The region will capture its share of Chinese growth and also benefit from deglobalization. Its 2 billion population will benefit from corporate capital relocation. For example, Apple is moving more production from China to India, and Adidas already produces 40% in Vietnam. State finances and central bank policy are stable and orthodox in the region. A number of countries have managed inflation proactively.
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- On the sector level, we see opportunities in real estate. Listed real estate has been more volatile than usual in the current context of rising interest rates and a deteriorating economic environment. The repricing of listed versus physical real estate is dramatic, as property values have not moved. Direct asset repricing has only started in H2. The average discount to NAV in listed real estate is now at 50%, which implies a 30% repricing of underlying assets and a 1.6% increase in property yield. If the market is correct, this implies stress on balance sheets that will need to be solved through dividend cuts, forced selling, and rescue rights selling. Highly-leveraged companies are still in denial, but it has already started with Castellum, TAG Immo, Unibail, etc. However, we have also recently witnessed transactions for accretive growth reasons, which is a positive thing (WDP, Montea, …). Unlike the broader market, we believe we have seen most of the decline in listed real estate and are approaching capitulation. New investors will want to see this happen before stepping in.
