Value Perspective Quarterly Letter – Q2 2022 – Global

Our quarterly note covering the Global markets

28/07/2022

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Have I been sleeping?

In the UK, Kate Bush is number one in the charts. Inflation is at elevated levels across the globe causing a cost of living crisis. And workers strikes are bringing widespread disruption to developed market economies.

Is it June 2022?

Or is it February 1978 when Kate Bush was the first female artist to reach number 1 with a self-penned song, inflation was 8%, and it was the ‘Winter of discontent’? 

Investors overuse the phrase ‘history doesn’t repeat, but it does rhyme’. But in this case, history does seem to be repeating. Just as some investors appear to be repeating the same mistake that investors often make – mistaking an investment cycle for a new paradigm.

This particular cycle was a big one. Driven by investors’ infatuation with growth, fuelled by low interest rates, free money, and excessive risk tolerance, global investors have been drawn towards the glittering lights of the tech-stacked US stock market. Back in 2015  the US market accounted for half of MSCI world in 2015, but by 2022, accounted for two thirds of the entire global benchmark and was significantly over-valued to boot. 

In a rare demonstration of forecasting accuracy (maybe)  our Q4 ’21 quarterly letter concluded stated “The US trades on a CAPE in excess or 40x. There is no doubt this is nose-bleed territory: data from the last 120 years shows that investors have never gone to make money over the subsequent decade when asked to pay such a lofty valuation.”

There are still 9 and half years to play out of course, but year-to-date the US has borne the brunt of the valuation-led market sell-off.

Year to date market total returns

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Source: Schroders, Morningstar, as at 30 June 2022. Returns are net calculated in base currency for each index shown.

On the other hand, the UK stock market has held up well. How has the UK achieved this? Through the things that are here, and the things that aren’t. It has large weightings in sectors that have been out of favour for the past ten years (banks, oil & gas and mining), all of which are now in demand as their cycle has turned, leading to profit and dividend growth.  On the flipside, the UK lacks a large tech sector (one of the reasons people went global), but it’s the tech sector which is dragging down global indices, with the S&P now in official bear market territory, and ‘non-profitable tech’ having it’s worst quarter ever. The combination of these two factors have led the UK to being one of the highlights of a difficult investing environment.

So where does that leave us going forward?

Looking at markets more broadly, losses so far have been driven by a reduction in the profit multiple investors are willing to pay for companies. Earnings forecasts, in aggregate, have yet to move. If we take the S&P500 as an example, while the market is down, analysts currently believe corporate earnings will increase by nearly 10% in 2022, in 2023 and 2024.

Consensus estimates, S&P 500 earnings per share

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Falling prices with a static earnings forecast mean the US market’s cyclically adjusted PE ratio (CAPE) has declined from 38x at the start of the year to 28x today. However, what is happening, is not dissimilar to what happens at the start of every economic decline. Analysts tend to wait for companies to announce bad news before adjusting forecasts for fear of looking stupid if it doesn’t happen, while the market as a whole tends to react in advance of downgrades. This weakness in the US market has provided us with the opportunity to look at a number of names they typically haven’t been able to historically and is where they have been spending the bulk of their research time recently.

Higher interest rates will inevitably impact consumers. That is the entire point of higher interest rates. In an attempt to contain price increases, the Bank of England, the Federal Reserve, and the other Central Banks of the world need to reduce demand to better match supply and demand. The only tool they have is a very blunt one – interest rates. And if people have to lose their job to achieve price stability, Central Bankers believe that is a price worth paying.

As a consequence, the chance of inflation at 9%, and resultant higher interest rates, not having an impact on consumer spend is low.

So if the consumer is about to come under pressure, why have the most recent stocks we have bought all been consumer stocks? Because the stock market has moved in advance of the downgrades.

Although a potentially dangerous analogy for a variety of reasons, the current environment feels somewhat similar to the beginning of 2008 (please don’t take this analogy too far). In the first half of 2008, consumer stocks sold off aggressively in anticipation of an economic slowdown, whilst other areas held up as there was a belief that Emerging Markets (China in particular) would ‘decouple’ from the West. This time round, consumer stocks are selling off aggressively, whilst commodity focussed stocks are holding up due to forecasts of continued elevated demand for commodities driven by the forthcoming energy transition. Is history repeating, or only rhyming?

We don’t know. We have no greater insight into the likelihood of the energy transition propping up commodity prices as we did for China causing a decoupling. Just as we have no greater insight into the outlook for the global economy than corporate managements, who came into 2022 with unprecedented levels of optimism (coming into 2022 the G7 countries Business Confidence Index was at its highest point since 1975).

However, sometimes in financial markets we are compensated for running into a burning building. Today, there are some areas of the market where we believe this to be true. To ensure portfolios are well-positioned at the bottom of whatever ‘this’ is, we need to buy in ahead of the downgrade cycle being complete. It is entirely reasonable to believe downgrades will come. But have shares moved to fully price that in? It’s impossible to say. It is also impossible to rotate the portfolio on a single day at the very trough.

Our job, as always, is to continually tilt the portfolio towards the areas of opportunity. That means we are rotating away from the stocks which have done well for us over the past two years, the mining, oil and gas and banking shares. We are increasingly looking at cyclicals, but only where balance sheets are strong enough to withstand potentially tough times. The fear of looking naïve ensures few of our competitors will follow suit. This, however, also ensures we will be one of the few to benefit once ‘this’ is over. In the interim, while ‘this’ may be uncomfortable, ‘this’ will allow us to lay the foundations for the performance of the strategy over the next five years.

Author

Important Information:

The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German, Tom Biddle and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.

They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.