In Search Of A New Equilibrium

15 July 2022

Financial markets got even rougher in June, with (almost) nowhere to hide and making for the worst ever first half of a year for bonds. Worries are certainly galore: persistent inflationary pressures that are starting to feed into wages, economic slowdown verging on recession, rate hikes promising to push up the cost of debt, geopolitical troubles… Yet, this return to a more “normal” boom-bust economic environment has a silver lining for investors: the opportunity to gain exposure to “normal” companies at more “normal” prices.

As we write, the summer season is under way and consumers are spending as if there was no tomorrow. Supply-constrained travel infrastructures are under assault, particularly airlines and airports. The affluence at restaurants is such that serious prices hikes are being implemented – admittedly also to cover Ukraine-driven food inflation. The pent-up demand of the past two Covid-constrained years is unravelling fast, with spending having also shifted back from the online world to real “bricks-and-mortar” stores.

At some point, however, this demand will come to an end – and abruptly. The risk then is that recent investments being made into additional productive capacity prove unnecessary. Order intakes will drop markedly, newly built factories remain empty and company finances take a double hit. Indeed, not only must the cost of the investments be written down in the books, but the loans taken out to finance them, need to be paid down. This is a typical end-of-cycle phenomenon, well described in economic textbooks but never yet experienced by the younger entrepreneurs. Beyond the severe cost-cutting measures that will have to be taken, accessing capital stands to become much more difficult – a drastic change of backdrop for entrepreneurs who have grown used to free and unlimited access to money, quite regardless of their business results.

Similarly, living with persistent inflation is a new experience for many people. And seeing monetary policymakers respond to that inflation in the “normal” way, by hiking rates – particularly (and rightly) so in the US where there are currently two outstanding open positions per unemployed person – and reigning in bond purchase programmes is also new. In effect, we are shifting away from a world in which financial markets were flooded with money created by central banks, and economic cycles had all but disappeared, to one where both markets and the economy evolve more freely – involving booms and busts. Where the pendulum stops remains to be seen, but all economic actors are having to adjust to this more normal environment.

As investors, the key question is how much has already been priced in by markets. Looking at full-year European earnings, the stock market appears to be predicting a +/- 15% drop, versus consensus estimates that are the mirror opposite, still projecting 13% growth. This gap probably stems from the fact that most companies are doing well for the time being, courtesy of the strong afore-mentioned consumer demand. But order books are not looking that great, meaning that the second half could turn out much weaker. The pending earnings reporting season should thus see many managements revise down their guidance and analysts cut their estimates. From a historical perspective, the 15% earnings decline priced in by the market already speaks of a mild recession.

Which, together with the fact that the (largely ETF-driven) selling has been indiscriminate, means that interesting entry points are being reached on some stocks. We would point in particular to the automobile sector, where some “traditional” makers are now trading at only 5x net earnings (or even less), despite the latter being constrained by a lack of semiconductor components. Given the ongoing transition to electric vehicles, meaning assured demand for the next decade, the engineering know-how that these companies boast, and the massive cost cutting implemented since the “Dieselgate” scandal, we think investing in such names is a “no brainer”. And it is not just old-time car manufacturers that look attractive at current price levels, the investment case extends to the sector more broadly, including notably tire makers and battery specialists.

The energy sector looks particularly appealing as well. The latest data shows shale output now back to 2019 levels (but total US production still down because of the decline in conventional oil fields) and OPEC+ some 2.8 million barrels/day below its set quotas, of which ca. 1.5 million barrels is attributable to Russia. Note that the Russian deficit is not so much due to sanctions (its oil is being shipped elsewhere) but rather due to lack of technology and operators. The big unknown on the supply side is Saudi Arabia. The country says that it can produce 12 million barrels/day but never has it done so sustainably and its investments in oil fields have been limited of late. If supply cannot be extended much, which is our scenario, then a sharp drop in the oil price is unlikely – even in a recession scenario. This, we should add, is probably good news for the energy transition. Persistently high oil prices will not only force consumers to change their habits, but also give oil majors the financial means to make the necessary investments in alternative energy sources. The drop of energy stocks, in line with the general market correction, is thus not warranted according to our view and creates investment opportunities.

Turning to the fixed income space, with volatility presently extreme (during the second quarter US rates experienced a 120 bp rise, followed by a 50 bp pullback) and credit spreads trending up, we reiterate our cautious stance. Given the high inflation level, real yields remain in very negative territory for government bonds, ditto for investment grade credit. And buying high yield paper ahead of a possible recession is not the most attractive proposition in our view. Where investors can find some value is in emerging debt, with the average yield differential versus developed markets now at an all-time high. The selling having hit commodity exporters and importers alike, and the boom in commodity prices still having legs, our focus would clearly be on the producing countries.

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