Alongside the terrible human tragedy that has unfolded since Russia’s invasion of Ukraine, the war has also exaggerated many pre-existing trends. Some include the upward pressure on commodities and further disruptions to global supply gains at a time when inflationary forces have already been elevated.
The market has not widely observed stagflation (slowing economic growth at a time of accelerating prices) since the 1970s. At a high level it is not associated with rising equity markets due to the resulting squeeze on profit margins. Historically speaking, it also has not been a favorable environment for bonds; commodities and safe havens such as gold are regarded as the key beneficiaries.
This poses a big conundrum to central banks that do not want to choke off the post Covid-19 recovery, but also need to prevent inflation from affecting an escalating wage-price spiral. Interest rates are ultimately a blunt weapon, however, it is now widely believed that the US Federal Reserve (Fed) is behind the curve and but is doing its utmost to get back in the game. Current market expectations suggest a Fed Funds Rate north of 3% (currently 0.25%-0.5%) by early next year alongside a more aggressive tilt to quantitative tightening, which will equate to a further 0.25% rate hike.
The recent inversion of the US yield curve (10-year/2-year) is another ominous portent as it has a good track record of predicting future recessions, although the lags can be long (the median lead time from the last six inversions is 18 months).
In terms of the market’s reaction to both the war and the Fed’s policy pivot, commodities have already ratcheted higher and bonds have sold off sharply while equities seem to be in a state of denial. Against this uncertain backdrop, here are the seven key themes we are watching for in the months (and in some cases years) to come:
Recession or not, global growth is compromised
This has significant investment implications for all asset classes but the divergence in volatility between bonds and equities this year suggests a huge disconnect in thinking. The implicit assumption of equity investors appears to be that unemployment remains low and both household and corporate balance sheets are robust. In other words, the Fed will do a good job of taming inflation without engineering a recession.
However, history has shown that this picture can change quickly as growth dissipates. Moreover, wage gains are being eroded by inflation and consumers will need to use savings to provide any prospect of a soft landing. In the meantime, forecasts for corporate earnings this year continue to be revised upward, which suggests a reasonable degree of complacency.
Wall Street is not Main Street, but it seems very unlikely that the positive momentum behind equities that investors have enjoyed since 2009 will persist with the same vigor, particularly given the starting valuations of many of the index heavyweights. However, many areas, including a long tail of stocks outside of the mainstream benchmarks, are far more attractively valued and the bar to outperform is balanced in their favor. We expect there to be a wide dispersion between the relative winners and losers across the universe given the many forces at play.
The Ukraine conflict will not be another forgotten war
The implications of Russia’s invasion of Ukraine are significant, given its strategic location on the border of NATO countries and its importance as a supplier of raw materials. A wide range of outcomes is possible but a stalemate associated with a long-running simmering conflict has the potential to result in large swings in geopolitical risk sentiment for many years, regardless of whether it ultimately leads to a regime change in Moscow.
The direct linkages between Russia and the global economy are actually relatively small. Russia accounts for around 3% of Eurozone exports and we estimate that less than 0.5% of earnings from companies in the MSCI World Index is attributed directly to Russia. It is the broader impact of higher energy prices and contagion via further dislocations to global supply chains that is far more significant but also harder to quantify.
China’s response is also critical in setting the geopolitical tone for years to come. A new cold war fought along economic lines with China and Russia in the same camp would be highly damaging at a time when the need for international cooperation in the energy transition is imperative. At the very least, it appears as if the trend away from globalization in trade relations will accelerate.
The rising importance of a thematic perspective on both risks and opportunities will need to be explicitly incorporated into investment processes. Moreover, with greater uncertainty there will be an increase in overreaction to changing events. With the appropriate discipline and risk management, there are still plenty of good opportunities to invest in good companies at great prices.
The key transmission mechanism is commodity prices, which could remain higher for longer
Rising cost pressures are the main concern in the short run, particularly for those companies that have less pricing power (e.g., staples). A good proxy for this is both the level and stability of profit margins, which are explicitly incorporated within the QEP Quality Framework. We believe companies that are showing evidence of withstanding margin pressure and have healthy, although not necessarily the highest, forward growth expectations without excessive financial leverage are best equipped against this backdrop (e.g., pharmaceuticals).
Aside from the direct short-term impact on input costs, higher commodity prices complicate the longer term prospects of a successful global energy transition with significant implications for positioning within the energy sector today. The paths to net zero are broad and unlikely to be coordinated with significant implications for value chains and capital spending.
The investment required for the necessary transition is immense. The International Energy Agency’s (IEA) Net Zero 2050 scenario suggests that energy capital investment will need to rise from 2.5% of GDP today to 4.5% by 2030. This will divert investment from existing “dirtier” projects at a time when such materials are crucial to building a cleaner economy.
The risk here is “greenflation,” where we observe much higher demand and prices for copper, lithium, aluminum and other minerals. Paradoxically, the extraction of these metals and minerals, which all have a high carbon footprint, must be balanced against the longer term benefits. Once again, there will be winners and losers, but we are assuming that most commodity prices will remain elevated for a sustained period. For oil specifically, a potential deal with Iran and the US releasing strategic reserves will only go some way to mitigate the gap between supply and demand.
Ironically, sustainability-focused investors have sharply underperformed their less environmentally aware peers of late because of this upward adjustment in commodity prices but capital markets have a critical role to play in financing this transition while mitigating the risk to long-established business models. A simple approach of divesting from all fossil fuels may be risky but in our view there need not be a compromise. Investors should focus on identifying the best-in-class companies that are either leaders or enablers in energy transition.
The tailwinds behind big tech have abated
One uncertainty is whether, in a world where profitability will be harder to source, the market instinctively defaults back to growth for security. So far this has not occurred and if anything, the market appears to be quite discriminating in terms of distinguishing between those with more sustainable earnings and the longer tail of more speculative narratives.
Despite a strong run during the pandemic, a good example would be “profitless” tech, which has underperformed sharply in the past year alongside other high-profile causalities of excessive optimism (e.g., Netflix). With a few notable exceptions, pursuing such stocks has not historically generated a sustainable source of returns and more broadly, it has not paid to continually rely upon exuberant market behavior.
Greater discrimination is healthy and a far cry from the narrowness of performance between 2017 and late 2020. While its impact may be overstated, one mechanism that may be holding back growth is that higher long-term yields make profits in the future less attractive.
Our working assumption is that big tech has reached an equilibrium in terms of its weight in the mainstream indices and its broader influence within society; further gains or losses from here will be more stock specific in nature. In other words, jam today will be prized more than jam tomorrow.
Market overreaction has, however, generated many opportunities within “quality growth” areas, which, in our view, have also been left behind in recent years and, rather unusually by historical standards, can be a sizeable allocation within a value-focused portfolio.
The case for “value” remains compelling but…
The long-awaited revival in value investing that commenced in November 2020 may appear to have swiftly run out of steam during 2021. Such a short recovery would be highly unusual but, more importantly, there remains a significant disconnect between the relative performance of cheaper stocks and their fundamentals, at least when measured by forward earnings growth. Using MSCI’s style indices as a proxy, this is most apparent in the US market where the 50%+ underperformance of the Value Index since 2017 has not been justified by the progression of expected earnings.
Why you should avoid value traps
The case is even stronger when we further distinguish within the value universe among those stocks with stronger fundamentals. Indeed, a comparison of value, quality and the intersection of value and quality (i.e., affordable stocks with good fundamentals) suggests the best returns will be found in “quality-value,” in line with long-run performance.
The current valuation discount associated with this cohort of quality and value stocks implies a three-year outperformance of 12% for them to return to their long-run discount to the market, after considering expected growth. A good example of attractively priced quality is pharmaceuticals, which is currently trading on the widest discount to the broader market since at least 1995.
The key to value investing over the long run, but particularly during times of economic or market stress, is avoiding value traps.
Financials are a good case in point. Banks are noteworthy as a traditional value area of the market and are highly represented in value-focused portfolios and the corresponding style indices. However, they are also handicapped by a squeeze on their net interest margins from a flat yield curve and the prospect of slower credit growth. While the sector has come a long way from the excesses of the pre-GFC era, once again it pays to be selective and focus on asset quality.
Emerging markets are cheap for a reason and should be assessed bottom-up
A similar argument for being selective can be made for emerging markets, which are often lumped together and thereby exposed to high level asset allocation calls rather than a more nuanced assessment.
The emerging market universe is in fact highly diverse with a variety of drivers. The simple split between commodity exporters and net importers of resources has been very apparent in the past year with Latin America, the Middle East and South Africa riding the tailwinds, in some cases propelled further by currency appreciation (e.g., Brazilian real and South African rand). On a related point, Taiwan and South Korea are more vulnerable, given that they are more geared into global growth due to their high export content.
Meanwhile, China has fallen from favor due to its regulatory crackdown on several key sectors, not least the forceful clampdown on its tech giants during 2021 in favor of common prosperity. This was further compounded by the uncertainty about the extent of China’s support of Russia and the ongoing risk of US regulators delisting Chinese companies due to insufficient audit documents that back their financial statements. In response, Beijing has recently offered an olive branch by signaling its broader support of the market, which investors took to mean as an end to the regulatory intervention for now, and cooperating more closely with the SEC on US-listed Chinese stocks. Alongside this China is struggling with a faltering property market and its zero-Covid-19 policy will severely hit growth this year as rising infections led to citywide lockdowns, although it will most likely be countered for additional credit stimulus.
More broadly, unlike previous crises in emerging markets, the threat of contagion from a Russian default appears limited as short-term external debt (as a % of FX reserves) is lower than has historically been the case and exchange rates are also more appropriately valued. In summary, opportunities in emerging markets should be considered bottom-up while fully recognizing the broader top-down risks, which are more elevated than at any time since the Taper Tantrum of 2013.
QEP response and actions
While the essence of the above seven points boils down to a higher-than-normal degree of investor uncertainty, it also nurtures a more conducive environment for active management. Our approach is firmly rooted in the trade-off between value and quality, which leads to a range of themes across our portfolios that are well suited for a broad range of market environments (see table).
The key is to ensure exposure across most of these themes, ensuring that no single environment dominates strategy performance. Alongside being more selective at the stock level, a focus on quality will be important, as will ensuring a balanced approach to growth while avoiding overpaying.
- Given rising cost pressures and the ongoing disruption to supply chains, we are currently dialing up the importance of margins in our quality framework. In practical terms, this means stressing our view of quality for companies that have historically been vulnerable to margin compression in favor of prioritizing those with stable and ideally rising profit margins where available. The starting point is also critical as those companies with a stronger margin buffer are clearly better placed to weather the potential storm. Having balance sheet flexibility is also important in terms of preferring those companies that can afford to absorb temporary cost pressures. Given that “real- time” adverse trends in margins are embedded in analyst forecasts, it may also suggest being more aware of the direction of short-term analyst EPS revisions. However, we are also conscious that we are past the peak of the current earnings cycle and analysts are almost certainly too optimistic at present. In response, we are scenario-testing our quality models to ensure that there is a sufficient margin of safety between structural and cyclical winners. This is a key research focus for the team at present.
- Without being alarmist, we are also attempting to recessionproof our portfolios by being more cautious on companies employing a high degree of short-term funding, effectively raising the financial strength bar. For example, there are plenty of examples of very cheap retailers and stocks within emerging markets that have had to survive on very high levels of shortterm debt in order to survive the Covid-19 crisis. If economic demand does disappoint, the goal posts for these stocks will have moved again and the chances of government support are not guaranteed. Scanning the wider investment universe provides more scope to identify the best opportunities after weeding out the potential value traps.
- There will be few places to hide if equity markets do reprice but we urge being very discerning in areas such as staples, which generally struggle to pass on higher costs, particularly at a time when their bond substitute premium has eroded. A preferred defensive area in our view is healthcare, particularly pharmaceuticals, which have performed well recently but are in aggregate still trading on historically low multiples given their underlying quality. It is worth stressing again that the usual trade-off betweenvalue and quality is not as evident today and it is possible to build a value portfolio with a PE of 10x forward earnings with the same fundamental characteristics as the broader market, which is trading on a multiple of almost 18x.
- Within deep value, we continue to advocate a hedged approach with very selective exposure to cyclical areas(i.e., avoiding those with any signs of financial distress or deteriorating fundamentals, particularly those facing longer term structural headwinds) balanced against a broader array of higher quality stocks with adequate free cash flow and quality backed yield. These are the tangibles that will most likely be in demand against a weaker growth backdrop but having a broad approach to value with exposure to earnings, cashflow, dividend and asset-based valuation characteristics has been the best approach over time.
- A natural hedge to rising inflation within equities can be found in the resources industries, although sustainability considerations do limit the scope of significant allocations and stock prices have already adjusted sharply. We are more focused on best-in-class companies, i.e., those with credible carbon transition plans or those that already have stronger environmental credentials. In our more value-focused strategies, we are overweight across commodities as well as the closely associated marine freight stocks, which forms a natural hedge. These areas are still very cheap despite the structural tailwinds that have been in place for many months. We expect this overweight to persist for some time.
- As noted already, banks have come a long way from the profligacy of the pre-GFC era. Once again, it pays to discriminate and focus on asset quality. The banking stocks that we own are well capitalized. In Europe, banks were already trading on deep discounts to their book values even before recent events but given the balance sheet repair we have observed over the last two years , we remain selectively comfortable for now. Indeed, the recent de-rating of EU banks has in our view been indiscriminate, albeit not an unexpected overreaction in these circumstances (i.e., selling all stocks quickly rather than waiting for asset exposures to be reported).
- We will also continue to add to quality growth without overpaying, by focusing on companies with improving prospects that we regard as more durable during a period of rapid disruption. We have further supplemented our work in 2020 in identifying those companies with the best forward growth characteristics by incorporating measures of historical cashflow generation supplemented by R&D investments that are expected to be accretive. As noted, the multiple compression that has been evident in many of these overlooked stocks in recent years provides plenty of strong opportunities.
Our current research agenda is aligned with identifying structural winners and avoiding the potential for relative losses while continuing our focus on thematics and sustainability, particularly relating to climate transition and social trends. The latter in particular has not been widely recognized, but is likely to be even more pertinent given that the ongoing squeeze on the cost of living is likely to increase social inequality in the years ahead.
Geopolitical crises have historically provided a buying opportunity for equity-focused investors. However, it is less widely stated that the main caveat to the resulting “buy the dip” response is whether the crisis then goes on to precipitate a recession. This is still not currently a consensus view, but the odds have certainly declined. Moreover, the fact that Russia seems likely to remain isolated from the rest of the world for the foreseeable future does increase the risk of unprecedented retaliatory measures.
Clearly, the situation remains very uncertain and a high degree of caution is warranted. This need not derail the broader attractiveness of seeking out good value opportunities as the excesses of the 2017-2020 period have only partially unwound, although avoiding value traps will be even more important. The unusually high representation of defensive stocks trading on relatively cheap valuations means that investors do not need to head for the hills in search of safety.
Equities are currently far more sanguine than the bond market, which seems unlikely to persist. At the very least, the elevated level of uncertainty about the geopolitical and macroeconomic environment suggests that equities will be more volatile and prone to larger swings in sentiment. The view that the Fed is now playing catch-up feeds into this uncertainty.
As a final comment, we note that periods of moderate market volatility have historically provided a favorable backdrop to our diversified approach, as it tends to generate short-term opportunities. Being able to harvest excess market volatility by trading efficiently (little and often) may well be a bigger driver of relative performance this year than making less predictable top-down calls.
This paper is available as a pdf below: