Equities: War, energy shocks and ‘apocalyptic’ inflation – finding opportunities amid uncertainty

You’ve heard what they say about yesterday’s news. But, in a year where a lot has changed in a very short period, what should we make of December’s outlooks?

War, energy shocks and ‘apocalyptic’ inflation – things have escalated a lot since year-end. But what impact have these crises had on equity markets, and did our views materialise? We share our thoughts.

We were optimistic on Europe at the start of the year. Despite the headlines, we remain so, given attractive valuations in many segments of the market alongside particularly pessimistic sentiment.  Returns are typically greatest as markets climb walls of worry.

There’s strong evidence that we’re in a markedly different environment today compared to post-global financial crisis (GFC) and during COVID. Portfolios need to acknowledge these changes. But we believe, this is still a good opportunity for the longer-term investor, despite the near-term growth challenges because of China lockdowns and the Russia/Ukraine conflict. Of the three trends we previously outlined for 2022, the direction of travel remains supportive.
 

Themes expected to work

Another crisis, this time the war in Ukraine, has highlighted the need for Europe to become less dependent on others for energy and other goods. This should accelerate the transition to renewables.

It’s another reason why we believe regionalisation, and not globalisation, is likely to be a dominant driver for many years to come. These themes, as well as higher defence spending, will require significant investment from both companies and governments, supporting growth in the cyclical parts of the market.  
 

Bond yields have risen markedly this year

As it became clear inflation wasn’t transitory, central banks began hiking interest rates. Shorter term, markets are grappling with what this could mean for economic growth. For those with a medium-term horizon, the outlook for inflation and growth is quite different to the previous decade, when disinflation and stagnant growth were the norm. We believe the focus remains shorter duration equities vs the Growth/Quality darlings of the past decade.
 

Double digit earnings growth

Quarter one earnings are on track to grow by over 20% year on year (YoY)¹. From here, this rate of growth will slow. But we believe the market looks to have priced in a mild slowdown in many of the cyclical parts of the market. We believe valuations are compelling and in our view, there are opportunities here, especially with the near-term lifting of lockdowns in China.

In a volatile year, did our views materialise?

At the end of last year, we highlighted that inflation would put pressure on high value stocks, favouring shorter duration stocks in strategies with a fundamental approach to valuation. Within UK equities, we identified the opportunity to invest in a good range of long-term structural themes, like climate change and energy transition.

The terrible events in Ukraine have accelerated the pressures that were already evident to us:

• The rapid increase in energy prices.
• Consequential disruption to supply chains (exacerbated by the lockdown in China).
• Likely increases in the price of agricultural commodities.

These will continue to build over the rest of the year.

Year to date, equity markets have favoured shorter duration stocks in strategies with a fundamental approach to valuation, over high value stocks in momentum type-strategies. And, for the first sustained period since the referendum of 2016, UK equities have outperformed the US, continental Europe, and Japan.
 

Long-term trends are emerging

As with everyone reading this note, we hope that lasting peace can soon be found in Ukraine. But the underlying pressures on inflation and on companies are unlikely to reverse any time soon.

Peace or a de-escalation may moderate energy prices, and year-on-year inflation is likely to have moved past its peak by the end of the year. However, the desire to accelerate energy transition and achieve greater self-sufficiency, and a general shift towards onshoring vs offshoring, will be with us for some time. In summary, the next ten years are going to look very different to the last ten.
 

UK outperformance: more to come?

Despite the outperformance of the UK year to date, we believe there is much more to come. The below chart looks at the valuation of global markets based on more than 2,000 observations over 20 years (each dot is a month in a market). It plots price-to-book (P/B) against return on equity (ROE). In other words, it recognises that:

• Higher returns re-invested for higher growth merit a higher market valuation.
• As returns change over time, so should the price of equities.

Looking at the latest pricing of indices relative to the model valuation, the regression line indicates that the US has just under 10% downside (from ‘growth’ styles). But the UK – with its feet firmly grounded in ‘value’ – still has around 20% upside from here. 

Inevitably, there will be near-term volatility. But the bottom line is that the improved outlook for UK corporate earnings and for nominal growth should, in an undervalued market, boost the outlook for UK listed equities. Key beneficiaries will likely include high quality, cash generative businesses, which form a significant part of our portfolios.

Markets are concerned about inflation, policy normalisation, the war in Ukraine and the resurgence of COVID in China – and rightly so. The uncertainty is causing a reassessment of equity risk premiums across asset classes.

But two years into the pandemic, it’s becoming endemic. This suggests that re-opening potential in China and the rest of Asia is about 12-24 months out. Inflation is less of a concern in Asia than in the US, suggesting greater policy flexibility, which should also be supportive for markets.

The valuation of Asian equity markets has dropped markedly over the last 12 months from 2x price/book to today’s 1.5x². Buying the market at these valuation levels has historically led to decent returns on a 3-5-year view, despite a likely downgrade in consensus earnings growth estimates for 2022. This is leading to heightened volatility, which we view as favourable for stock pickers.

The recent weakness in markets has been particularly acute in those parts driven by sentiment, like the non-profitable technology, healthcare and electric-vehicle related sectors. We believe these areas are overvalued and have therefore avoided them.

In line with our investment approach, we invest in undervalued companies, and this has led us to be relatively well positioned for the latest rotation from growth to value stocks. As the economic recovery continues, cyclical parts of the markets have done relatively better.

We continue to find undervaluation opportunities in China which is now trading close to 11x forward price to earnings ratio (P/E) and 1.3x trailing book value², both below long-term historical averages.

We currently favour Indonesia over India because of differences in valuations. We also believe that the Indonesian economy is likely to be more resilient in an environment of higher energy and commodity prices.   

Following one of the strongest starts to a year, with more than $25 billion (around 85% of total net inflows)³ going into equity ETFs in January, the investment climate has turned more unsettled for obvious reasons. Many investors appear to be adopting either a risk-off stance within their portfolios or a ‘wait and see’ attitude, with question-marks over the path of economic growth and inflation.

It’s been evident for at least the past several years that investors are turning to ETFs irrespective of market conditions, although their choice of exposure can vary significantly. You could point to the way ETFs are traded, with enhanced liquidity and ability to buy and sell throughout the day being advantages in turbulent times.

While many investors are currently using ETFs to construct portfolios, either entirely or in combination with other types of vehicles, we could reasonably expect that other investors may be using them now to maintain market (beta) exposure, possibly with the view of eventually transitioning to actively managed funds.

We believe low-cost core beta ETFs are likely to continue playing meaningful roles in diversified portfolios and, based on recent flow data, we may reasonably expect further allocations to ETFs with environmental, social and governance (ESG) objectives. In the first four months of the year, the strongest trends have been into those ETFs with climate-specific objectives or that apply either a strict best-in-class approach or tilt weighting toward companies with stronger ESG characteristics.

We believe investors may also wish to consider deploying a portion of their risk budgets in thematic areas to capture potentially less correlated growth opportunities. Examples may include themes related to meeting environmental challenges or using disruptive technologies. 

Disruptive technology also remains a strong theme, with blockchain continuing to provide companies in a range of industries the opportunity to improve efficiency and reduce costs.