Shifting the focus from valuations to earnings
Welcome to our latest market update
This month we’re taking a look at the investment landscape with a particular attention to shifting the focus from valuations to earnings. We’re grateful to our friends at James Hambro & Partners for their help in pulling this together.
As always, we hope you find our updates both useful and insightful. Should you have any questions or wish to discuss anything in more detail then please just get in touch with your adviser, whose details you will find at the end of this email.
The hope for more stability
As we enter the second half of the year, it’s fair to say that investors will be hoping for more stability from markets and reasons to be optimistic following an astonishing period which saw the S&P 500 drop by 21%, its worst performance for the first six months of any year since 1962. In this period, European equities finished down nearly 20% and emerging markets fell over 12% (all in local currency terms). UK equities have fared rather better with only a modest decline because of the weighting within the main FTSE100 Index to energy – the only global sector to have provided a safe haven and positive return, year to date.
If we expand and focus on the FTSE250 index (which is less global in its revenue and profit generation) then the -20% performance from the index year to date reflects the material challenges the UK continues to face. Looking at fixed income, government bonds have been hit as markets moved to price in significant further increases in interest rates on top of what has already been announced. Markets now expect interest rate rises to 3.4% in the US and 3% in the UK by next year. We think that may be a little toppy, but who really knows.
In some of our recent communications we have written about the reasons for financial markets falling. These have included rising inflation expectations, an outbreak of war in Europe, further COVID lockdowns in China, and global central banks (led by the Federal Reserve) completely reversing monetary policy in a very short space of time. What is important to highlight though is that the rapid sell off in equity markets year to date has been driven by declining valuations rather than a shift in earnings expectations.
Valuation multiples on developed markets stocks have slipped back from close to 20x forward earnings at the start of the year to around 15x today. Over the same period, earnings growth expectations for 2022 have surprisingly been upgraded from 7% to more than 10% in a time when the economic outlook has deteriorated. The oil majors and booming energy prices have played a large part in these resilient earnings expectations while, in contrast, consumer facing businesses have suffered as inflationary pressures focused investor’s attention on a much tougher outlook for disposable incomes.
It remains to be seen whether we see a resolution to the war in Ukraine any time soon, but a reversal in earnings revision ratios in the near term is becoming more likely as analysts catch up with stock prices and issue a larger number of downgrades versus upgrades. The good news is that valuations, in every major region other than the US, are now well below their average since 1990 which should provide some support, given we’re starting from a lower base.
Watching the US
As a key determinant of global markets, we and our investment partners continue to monitor the US economy very closely. It’s worth noting that consumer sentiment has fallen sharply despite unemployment remaining low and wage growth strong. We are mindful that the Federal Reserve has indicated it is determined to get inflation under control and forecasts that unemployment will need to rise to just above 4% to do this.
We are also starting to see signs of higher interest rate expectations weigh on aspects of economic activity such as housing with 30-year fixed mortgages rising from below 3% to over 6%, resulting in a sharp decline in new housing starts as affordability declines. Having said this, we do not see a repeat of the 2008 housing crash as 95% of Americans are on long term fixed-rate mortgages which means we are likely to see fewer forced sellers.
As one might expect, this side of the pond, European consumer confidence remains rock bottom. Fears over outright energy shortages and rationing as gas supplies from Russia are reduced and prices go through the roof are playing a huge part in this. To make matters worse and to the surprise of some, the market is now pricing in significant interest rate rises from the ECB which are stoking fears of another Eurozone sovereign debt crisis as Italian borrowing costs rise. As recession fears mount, we have seen the Euro come within a whisker of parity with US dollar for the first time in 20 years.
Those three scenarios
In our first communication in June, we discussed three broad scenarios for how things may develop over the course of the year; an economic ‘soft landing’; a recession with moderating inflation; a recession but one with stubbornly high inflation. A ‘soft landing’ whereby central bank policy and post-pandemic normalisation reduces inflation without causing a significant deterioration in growth and levels of employment would be a favourable result for equity markets and for consumer-facing companies.
However, since we set out these broad scenarios, the recent news flow suggests this ‘soft landing’ scenario is going to be harder for central banks to achieve.
The US labour market is unambiguously tight with data released last Friday showing the nonfarm payrolls (number of workers in the US excluding one or two job classifications) grew by 372,000 month-on-month in June, more strongly than the expected 268,000, while the unemployment rate remained at 3.6%. If a ‘soft landing’ scenario is to be achieved, wage growth will need to moderate significantly to a level which is consistent with the Federal Reserve’s inflation target, without unemployment rising materially. Whilst the Federal Reserve policymakers believe they can damp down labour demand enough to tame inflation without causing a recession, we are mindful that ‘soft landing’ tightening cycles which don’t end in recessions, have been rare historically.
We feel the balance of probability has shifted slightly more towards a recession with moderating inflation, with the recession risk materially higher in the UK and Europe than the US due to the energy crisis. We believe a recession with stubbornly high inflation remains less likely as we stand today with any US recession expected to less severe than a 2008 scenario. The reason for this is that we don’t see major financial imbalances such as signs of excess or leverage in the economy that we have done historically which would most likely lead to a prolonged downturn. Consumer balance sheets are in pretty good shape whilst the Western banking sector has spent the last ten years rebuilding and preparing for a recession.
How can history guide us?
The chart below looks at several previous recessions and compares the peak to trough decline in both price return and earnings. What the chart shows is that market moves to date are consistent with a reasonable slowdown in profits and that a substantial amount of bad news already looks to be priced in.
Even with expected analyst downgrades and pressure on profit margins ahead, it is important to note that much larger drawdowns have generally coincided with deeper and more sustained economic downturns.
We are always mindful that the market is forward looking and is now looking several quarters ahead factoring in the effect of Fed tightening - high commodity prices leading to a heavy discounting of cyclical exposure. Should any positive catalysts hit markets at the same time as absorbing well flagged bad news on profit forecasts (e.g. declining inflation figures, Russia-Ukraine ceasefire, China bounce back), we feel markets have the potential to surprise on the upside which would bode well for long term investors in high quality businesses.
We know well that no business is immune from recession and so we must ensure that the portfolios we choose for you in conjunction with our investment partners contain the highest quality companies that have pricing power, higher returns on capital, superior operating margins and conservative balance sheets. These core investments combined with the additional resilience built into portfolios more recently, should mean portfolios are better positioned to withstand any further weakness in markets, whilst importantly ensuring they are able to deliver attractive returns for clients over the long term.