No market for broad strokes investing

Heavy lifting done, still bumps ahead

It has not been an easy few weeks for markets, and we have just witnessed some signs of relief. So are we past the big dip or is there more to come? Our stance is that a lot of the heavy lifting has been done from a market downturn perspective, but there is likely to be further bumpiness ahead as the risks remain to the downside. The key question is ‘what is now priced in by markets and how should investors position themselves for the range of outcomes ahead?’.

At the beginning of April we published a note entitled ‘Market Complacency’. We were cautioning clients that markets were being too complacent and were not factoring in the risks ahead. In particular, one risk that we felt was not being factored in was the possible demand erosion brought on by the increased inflationary pressure. Coupled with existing supply bottlenecks, the possibility of a policy error by central banks, and the impact of the zero-COVID policy in China, we expected growth expectations needed to be revised down.

First steps toward weakening demand

Indications of weakening demand have been visible for some time. Consumer confidence in the UK, eurozone and US has been trending lower since 2021, when COVID-related government support began to be wound down.

Even with US consumer demand, which has been relatively resilient so far, we’ve started to see some cracks. For example, US gasoline demand is well below pre-COVID average five-year supply levels, which is most likely reflecting a higher gasoline price.

Meanwhile, in the manufacturing sector, the Global PMI is below 50 (indicating a contraction in activity), whilst new orders are only just in expansion territory. Even the US is not immune, with business leading indicators (e.g. ISM PMI and ISM orders minus inventories) trending downwards.

The benign Q1 earnings season could be misleading

The Q1 earnings season has been relatively benign. Less so on earnings, with the NASDAQ and MSCI Emerging Markets indices seeing fewer than 50% of companies beating earnings expectations. However, the revenue side has fared better than expected, with the majority of companies beating sales expectations across the major regional markets.

We should not extrapolate from this that demand will remain strong. Q1 was very much looking in the rear-view mirror. To gauge the direction of travel, it’s worth digging a little deeper and looking beyond the headline numbers.

When listening to company managements on their expectations as we move through 2022 the picture is not as positive, and this is what we have to watch for in next quarter’s results.

Across the US, UK and Continental Europe, we have heard a number of companies observing that consumers are starting to trade down, that there is rising sensitivity to promotions, and early signs of softening demand in consumer durables.

No more complacency in markets?

Since early April we have witnessed a substantial drop in stock markets and a rise in fixed income yields. More recently we have seen a tentative rally in stock markets and bond yields have fallen. Does this mean that all the bad news is already priced in? We believe that the answer is: ‘’partly, but not all, and it will depend on how bad the news ahead will be”. A lot of the heavy lifting has already been done by markets in terms of price declines, but risks remain to the downside, particularly in equity markets.

Certainly, following the April-early May drop, and the pervasive negative sentiment, markets are bound to be more sensitive to positive news. These could range from any sign of a resolution to the Ukraine war, to an inflation slowdown, or central banks being more cautious with tightening – and we are starting to see signs of this in the recent equity market bounce. Fixed income markets have also benefited from growth concerns superseding the prospects of further inflationary pressures and central banks tightening.

However, there are still risks ahead, not least the possibility that additional sanctions are placed on Russia, such as on natural gas, demand destruction leading to a recession, and possibly central banks overtightening in the inflation versus growth balancing act. Most of all, the impact that all of the above will have on corporate earnings. The key question is, how much is already priced in? The calls on stagflation and recession are widespread among market commentators, and we have even heard mentions of depression and a 2008-style credit event. In our opinion, a worsening growth outlook and a meaningful growth slowdown are priced in. There may be more downside, particularly in some equity names where valuations remain elevated or an earnings decline is yet to be factored in.

A meaningful recession, perhaps emanating from Europe, caused by sanctions on natural gas, would bring some further downside – particularly in equities. A depression or a 2008-style collapse of credit markets where companies and individuals struggle to pay back debts is not priced in and is not our base case scenario. All of this means that any market bounce will be data and news-flow dependent and could potentially be short lived.

For this reason, in our multi-asset strategies during the first half of May and following the sell-off, we moved from an underweight position on duration and a neutral-to-underweight position in equities to a neutral position on both asset classes. Our neutral stance is predicated on a meaningful sell-off having just taken place and yet the acknowledgment that risks ahead remain. We still remain cautious and selective and hold higher-than-usual cash balances. Our belief is that this is not a market to take outsized directional positions. Rather, it is a market to preserve capital and wait for a better opportunity. 

Within equities, we have taken advantage of market volatility by selectively buying into some names that have significantly derated, particularly following earnings announcements. There has been a case of babies being thrown out with the bathwater, and we have picked up some of those names, but have been very selective in our choices given the uncertainty ahead. The wide earnings results disparities within the same sectors are a reminder of the need for careful sifting. Technology stocks globally have provided some interesting opportunities.

Much has been said about the change in correlation between equities and bonds. Depending on whether growth or inflation are at the forefront of bond investors’ concerns, we may see the two asset classes moving in the opposite or similar directions. Importantly, when comparing yields, equities are still looking optically cheap versus bonds. However, much depends on the earnings outlook from here. As mentioned, while a relatively benign earnings season is behind us, moving forward we could start to see more widespread cracks in companies’ results.

Positioning in a volatile environment

In this environment, and given the uncertainties ahead, we believe the best positioning is holding a diversified portfolio across different asset classes, including equities, fixed income, commodities and real assets. Within asset classes, selection is key. Alpha is bound to come from selection. This is not a market for broad-strokes investing. When investing at a company level, it’s important to focus on companies with pricing power and strong balance sheets, those able to better withstand the inflationary and rising rates environment. Within equities, we continue to favour long-term themes, that we believe have longevity and will benefit from investment ahead, independent of the vagaries in the macro outlook – such as infrastructure and the low-carbon ecosystem.