Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Equities: tangible assets and profitable growth are the winners
Peter Garnry
Chief Investment Strategist
Summary: The past six months have seen the biggest shift in market sentiment in a lifetime catapulting financial markets and the economy into a state few investor, if any (maybe except for Warren Buffet and Charlie Munger), have ever experienced.
The V-shaped recovery is dead this time
The past six months have seen the biggest shift in market sentiment in a lifetime catapulting financial markets and the economy into a state few investors, if any (maybe except for Warren Buffet and Charlie Munger), have ever experienced. That in itself calls for humility and caution as we all sit on a runaway train that will probably derail into a difficult situation.Unfortunately, the memory of today’s investors has been shaped by the relentless bull market of the past 10 years, and especially the last five. This has resulted in few investors being really prepared for what might happen as we deal with the consequences of the physical limit that the world has arguably hit. Central banks and businesses were used to a flexible and ever-expanding supply function. However, the supply function of the world economy has for good reasons become inelastic, which means that any demand push goes straight into inflation.
Despite a galloping energy and food crisis, runaway inflation and a historic move higher in interest rates globally, the MSCI World Index was still valued above its historical average by the end of May. Given the current outlook and interest rates level, the equity valuation on MSCI World should be below average. Earnings for global companies are already down 10 percent from their peak in Q2 2021 and the outlook is not looking rosy. However, this is not holding analysts back from giving a 12-month earnings per share (EPS) estimate on the S&P 500 that is 18 percent above the earnings levels. A relentless bull market over 12 years, only punctuated once in a while by short-term V-shaped recoveries, has reinforced a buy-the-dip mentality and more risk taking. Investors are simply slow at updating their views, and we observe no material change in behaviour among retail investors, which is also why this equity market has more room to fall.
The S&P 500 Total Return Index is down 23 percent as of 16 June, which means that US equities are officially in a bear market. The big question is: Where and when is the bottom in the current drawdown? Our best guess is that the dynamics that best describe the current drawdown are the ones during the dotcom bubble and the 1973–74 energy crisis drawdowns because of the current commodity crisis and bursting of technology stocks. Based on the information picture we have today, our best guess is that the S&P 500 will correct around 35 percent from its peak, and it could take somewhere between 12 and 18 months to hit the trough, which means sometime later this year or in the first half of 2023.
As Sequoia Capital put in their 52-page presentation on 16 May 2022 to the founders and the companies they have invested in: “This is a crucible moment. . . .[I]t will be a longer recovery. . . .[C]apital was free, now it’s expensive. . . .[G]rowth at all costs is no longer being rewarded.” The most important takeaway from Sequoia Capital’s views is that companies will no longer be rewarded for revenue growth but improvements in return on invested capital and free cash flow. The V-shape recovery will not happen this time and the bear market will likely not exhaust itself until the new generation of investors that went all-in on speculative growth stocks, Ark Invest funds, Tesla and cryptocurrencies have fully capitulated.
As Sequoia Capital put in their 52-page presentation on 16 May 2022 to the founders and the companies they have invested in: “This is a crucible moment. . . .[I]t will be a longer recovery. . . .[C]apital was free, now it’s expensive. . . .[G]rowth at all costs is no longer being rewarded.” The most important takeaway from Sequoia Capital’s views is that companies will no longer be rewarded for revenue growth but improvements in return on invested capital and free cash flow. The V-shape recovery will not happen this time and the bear market will likely not exhaust itself until the new generation of investors that went all-in on speculative growth stocks, Ark Invest funds, Tesla and cryptocurrencies have fully capitulated.
The rebirth of energy could cause an ESG crisis
In our Q1 outlook, we wrote that the energy sector represented the best expected return in the global equity market. This prediction has turned out to be true. The energy sector is the only one that’s gone up this year, driven by surging oil and gas prices due to lack of supply, which in turn is a result of a result of years of underinvestment. There’s also the more recent removal of a significant amount of the world’s supply stemming from the sanctions against Russia. The S&P 500 energy sector is up 42 percent year-to-date as of 16 June, while the S&P 500 is down 23 percent over the same period. The energy sector went from being one of the largest during the peak of oil prices in 2008 with a weight of 13.5 percent to being the smallest sector in October 2020 at 2.4 percent weight in the MSCI World Index. Since the mRNA vaccine rollouts, demand has come roaring back, pushing oil prices to the highest ever in EUR and revealing the inelasticity of crude oil supply and refinery capacity due to the low investment levels. The energy sector is seeing its profits and market value soar, pushing the sector weight to 5.2 percent in May 2022.Since the financial crisis, technology stocks have enjoyed ever-lower interest rates, inflows from ESG funds overweight technology stocks and expanding margins, while energy stocks suffered from low returns on invested capital. Long technology stocks and short oil and gas were the perfect trade over a 14-year period, reinforcing the mindset of investors. Note the inverse performance of the energy sector and the Ark Innovation ETF. Now things are reversing as the world realises that it still runs on diesel and gasoline, and that our growing wealth is inconveniently linked to rising carbon emissions. For every percentage point that the energy sector is getting relative to the other sectors, ESG will be under more pressure on performance, and the resurgence of fossil fuels could cause a crisis for ESG funds suffering from outflows over poor performance and lack of exposure to natural resources amid the new age of inflation.
Tangible assets are winning
Looking at the year-to-date performance as of 16 June 2022 across our theme baskets, it is clear what stands out. Commodities, the principal driver of the current supply side inflation, and defence stocks, being at the receiving end of Europe’s increase in military spending due to the war in Ukraine, are the only theme baskets that are up. The two best theme baskets among all the losing baskets are logistics and renewable energy. We expect these themes to continue doing well until equities hit bottom in the current drawdown. The worst-performing themes this year are crypto and blockchain, e-commerce, bubble stocks, nextgen medicine and payments. The red thread is that tangible assets are generally outperforming intangible assets as a function of the higher cost of capital-compressing equity valuations of intangibles from insanely high levels, as supply constraints in the physical world push up the prices of physical capital goods and components.The only exception to tangible assets winning is real estate. This is the part of the physical world that was sucked into the there-is-no-alternative (TINA) trade. This led to excessive valuation levels on residential homes and capitalization rates (across all segments) as low as 5.4 percent in the US in the second half of 2021, according to CBRE, down from 6.4 percent just before the pandemic. Low interest rates combined with tight supply in many urban areas in the US and Europe have pushed real estate into a position where it is quite vulnerable to rising interest rates in the short term.
If we look at the 1970s home prices in the US, tracked inflation translated into real rate returns of zero—preserving purchasing power—which was a much better performance than equities that failed to keep up with inflation during that period. In a normal inflation cycle, we would be positive on real estate for preserving purchasing power. However, when you start from very low interest rates and historically high real estate valuations, and couple those with a significant change in interest rates, it becomes difficult to be positive on real estate, despite it being a tangible asset.
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