Strategy
Consumer of Last Resort
The S&P 500 index is having its worst start to a year for over four decades, falling for seven consecutive weeks before rebounding at the end of May. The combination of central bank policy tightening together with multi-decade high inflation rates, a commodity price shock from the ongoing Russia-Ukraine war and renewed lockdowns in China, has made for a very challenging investment environment.
The pandemic has caused huge dispersions between different sectors of the economy and, similarly, inflation is having varying degrees of impact on different sectors, companies, countries and consumers. The need to shut down and reopen the economy caused unprecedented disruption and inflation is something investors in Developed Markets have not had to contend with since the 1980s. These dynamics have been equally challenging for policy makers, with Treasury Secretary Janet Yellen admitting that she was wrong about the path that inflation would take, noting there have been ‘unanticipated and large shocks to the economy that have boosted energy and food prices and supply bottlenecks that have affected our economy badly that I didn't - at the time – didn’t fully understand, but we recognize that now".
With growth slowing, inflation elevated, fiscal support fading and central banks raising interest rates, worries around a global recession have increased. As the global economy has become more integrated, the global cycle has been increasingly synchronised. However, the three largest economies in the world - the US, Europe and China - face challenges that are very different in nature and scale, with important implications for their outlook.
Short-term interest rates have risen substantially in the US, putting pressure on the more interest rate sensitive parts of the economy such as housing and discretionary consumer goods. While energy prices have risen in the US, the country is no longer a large energy importer so is more insulated from the commodity price shock compared to Europe, which is heavily dependent on imported energy. The problems in China are very different. Over the last two years, the economy in China was operating normally, excluding overseas travel, and the coronavirus was kept at bay. China never resorted to the stimulus measures that the West did and inflation has therefore been much lower. Their issue is the more recent Omicron outbreak and the strict restrictions across some of the country’s biggest and economically important cities to try and control it. Restrictions are now in the process of being lifted and it appears that regular testing will be used to try and better balance health and economic objectives.
With bad news dominating the headlines, positive stories about the strength of global labour markets, especially in the US, have been easy to miss. The economy has added 2.4 million new jobs over the first five months of the year and wage growth has been incredibly strong at 4-6%. While consumers have been under pressure from elevated inflation, the nominal purchasing power in the economy has remined strong. After an extended post-stimulus period of real retail sales gradually trending lower in the second half of last year, the figures have started to rebound again this year. The reopening of the economy has boosted consumption in the sectors most hurt by the pandemic with the likes of travel and leisure coming back strongly. As the CEO of American Airlines Doug Parker put it at a recent conference, “people want to get out there… there is a change in consumer behaviour and definitely moving from kind of cocooning in a house and spending on home improvement and moving out to life experiences.” Overall, second-quarter real consumption growth in the US is on track to be strong at over 3% annualised, up from an already high 2.7% pace in the first quarter.
With the US consumer again acting as the world’s consumer of last resort, it is important to closely watch developments in the labour market. Wage growth easing would be welcome as it would take the pressure off the Federal Reserve to increase rates too rapidly but, with corporate margins under pressure from inflation, there is a risk of a downturn in the job market. We are seeing early signs of this in Silicon Valley where Tech companies have shifted their focus from top-line growth to profitability. The headwinds are building after the breakneck pace of hiring that we have seen and, although we know that the labour market lags other economic indicators, strong labour markets are currently helping consumers weather this period of high inflation.
Equities
Valuations Closer to Long-Term Averages
Global equities finished the month of May at roughly the same level they started, masking a -5% intramonth decline before bouncing back in its final days. The market decline continued the prior year-to-date trend, nearing a -20% fall from peak. The weakness has been caused by the series of negative events which have unfolded: persistently high inflation, unrelenting war in Ukraine, rising commodity prices, extended lockdowns in China to enforce its zero-tolerance approach to Covid, ongoing global supply chain issues, and central banks’ adamance that they’ll do whatever is necessary to tame inflation. All of these factors increase uncertainty and lower expectations for future global economic growth.
These developments contrast with an environment of fiscal stimulus, near-zero interest rates and a growing consensus supporting TINA (‘There Is No Alternative’ to equities) that equity investors had grown accustomed to. Rising interest rates and recession concerns caused some investors to reassess the appropriateness of buy-the-dips and overweight/leveraged allocations to equities, and consider whether in fact there may now be reasonable alternatives to equities.
The hardest hit global equity market sectors are those most exposed to rising interest rates or to lower and more uncertain economic growth. There has been a -13% decline in the global equity market (year-to-date through May 31, including the late month bounce-back), compared to a -24% in Consumer Discretionary, and -22% in both Information Technology and Communications Services. Consumer Staples, Health Care and Financials fared considerably better at -6% to -8%. The standout sector is Energy, which is up +47%. Despite markets finishing the full month of May flat, underlying sectors largely continued their year-to-date trajectory: Consumer Discretionary -3.5%, Information Technology -1.5%, Financials +2.9%, and Energy +13.5%.
In market sell-offs investors tend to reduce exposure to their largest most liquid stocks first. In order to comply with their diversification requirements, the high market cap concentration of the largest US stocks mean that many mutual funds by default must underweight these largest stocks. A recent Goldman Sachs study noted the average US mutual fund is on track to deliver its first quarter of outperformance since Q1 2021, and that over the last five years underweight positions in the seven largest US stocks have been a -2.6% drag on the performance of the average mutual fund. The seven largest stocks (AAPL, MSFT, GOOGL, AMZN, FB, TSLA, NVDA) represent >20% of the S&P 500 and >40% of the Russell 1000 Growth indices, while the average fund holds a combined 8% underweight to these stocks. In 2022 these largest stocks have struggled, giving back all their 2021 gains, and as a result this large underweight position has been a large performance tailwind.
The bounce late in the month of May snapped a seven-week losing streak in the S&P 500, fuelled by comments from the Fed that there may be a pause interest rate hikes after the anticipated 50bps hikes in both June and July. This triggered a relief rally in the market – most noticeably in large cap long-duration Technology stocks which had fallen more than the market on fears that the Fed would have more persistent rate hikes as it focused on taming inflation.
The year-to-date market decline, paired with steady (or even rising) earnings expectations, has led to a significant de-rating in market valuations. The US one year forward P/E ratio of 17.1x is now only just above the post 1987 average of 16.6x, while in Europe a ratio of 13.6x is just below their post 1987 average of 14.4x. This de-rating of multiples has varied by sector, with cyclicals (Discretionary, Industrials and Technology/Telecom) down the most and defensives (Utilities and Staples) experiencing much smaller multiple compressions. Despite this, the most expensive quintile of stocks in both markets remain as expensive as any time since 1990 apart from the TMT bubble and during the pandemic. Low real rates have supported both the economy and asset prices in recent years, but as rates have risen that tailwind has turned into a headwind.