Private Banking

Cautious investors overweight mix of value and defensive stocks

Recession or stagflation warnings have been bubbling for months this year amid the war in Ukraine, a world increasingly divided along geopolitical fault lies, disrupted supply chains, coronavirus lockdowns in China and central banks determined to combat high inflation through tighter monetary policy.

The Federal Reserve has charted at course for the fastest policy tightening since the 1980s and its Chair Jerome Powell concedes it may be beyond his control to tame inflation without triggering a recession. For its part, the OECD observes that inflation is hitting living standards and reducing consumer spending across the globe, and business are becoming less optimistic about future production. Crucially, that hit to confidence is deterring investment, which in turn threatens to hurt supply for years to come. The organization slashed its outlook for global growth this year to 3% from the 4.5% it predicted in December and doubled its inflation projection to nearly 9% for its 38 member countries. As a result, fund managers globally haven’t been this bearish about the economy since at least 1994, according to Bank of America’s May survey, with 72% of respondents expecting growth to weaken in the next 12 months.

Anxiety that monetary policy makers’ efforts to tame rising input costs may begin to manifest in weaker profit margins has wiped out almost €9 trillion in stock market capitalization this year. With the MSCI World All countries down 8% (in euro), the stock market is pricing in 40% chances of an economic contraction, a lot higher than it normally does, according to a UBS model. According to JPMorgan’s estimates, US and European stock markets are even pricing in a 70% chance that the economy will slide into recession in the near-term. While similarly elevated recession odds tended to see further equity losses when a recession materialized, stocks usually rallied when the worst didn’t pan out. In that case, the S&P 500 index jumped 12% over the following 12 months, according to UBS. 

The historic pattern is something worth heeding for today’s investors who are exiting stocks, fretting the Federal Reserve’s campaign to tighten monetary policy and combat inflation will throw the economy into a recession. Even as signs the economy is weakening, especially in China and Emerging Markets, sniffing out evidence an outright recession is on its way is still tough. Manufacturing and services activity is off its peaks but still in expansion at the global level (see the chart). Consumers are sitting on excess saving and continue to spend, while employment and corporate earnings don’t scream danger. The fundamental backdrop still points to a continued expansion - one that is either in the middle or late stage of an economic cycle – and even if equity valuation are not at bombed-out levels , they have cheapened significantly – they trade at 15.3-times forward earnings, versus 19 at the beginning of the year. In other words, risk/reward could still be attractive when this much recession risk is priced! 

evolution of composite PMI indices

Furthermore, equity investors’ anxiety about a potential recession isn’t showing up in other parts of the market - 50% chance priced into the investment-grade debt market, 30% in high-yield debt and up to 20% in rate markets, according to JPMorgan -, which is giving confidence in a relative pro-risk stance. 

  • Bond investors see inflation subsiding from recent highs, even as commodity prices continue to rise, underscoring the view that central banks are likely to risk recessions to tame cost pressures. The U.S. five-year breakeven rate - a key indicator of debt market expectations for inflation within 5 years - has slipped 0.6% since its recent peak on April 22, to just 3%, while crude oil has jumped 50% in the same period.
  • Even if inflation has reached 40-year highs at above 8% a year in the US due to supply shocks generated by war in Ukraine, lockdowns in China and the lingering impacts of the coronavirus pandemic around the world, bond markets are starting to believe that inflation can be somewhat subdued as the Fed will destroy demand through its aggressive rate hiking program and material tightening of financial conditions – U.S. financial conditions are now their tightest since the first Covid lockdowns. With the Fed tightening cycle increasingly fully priced, real bond yields have probably peaked. Yield curves could continue to flatten in the coming months as the global growth outlook softens.

We are therefore in a situation where either equity markets prove right and a recession takes place, inducing much bigger declines in bond yields, or rate markets prove right and a recession is avoided inducing a recovery in equity markets. In this unstable context, equity investors should continue to focus on hedges. Prospects for equities generally will dim should concerns about stagflation or recession become a reality. But in this scenario, there will still be relative outperformance, dictated by things like low duration, pricing power, high dividend yield, low volatility, less cyclicality (see the chart).

Performance of the main investment factors

  • When it comes to finding a safe haven in stocks, value stocks, which are characterized by a low duration, should continue to perform better than growth stocks as they are less penalized during rising inflation expectations and higher interest rates. Year-to-date their outperformance amounts to 18% (in euro) ! Among value sectors, the one that is most preferred right now is energy (+60%). According to Bank of America’s May fund managers’ survey, a net 50% of European investors are overweight in the sector, the highest since 2008, based on an elevated oil price - lower global oil inventories and little spare capacity to boost production has helped to underpin this year’s almost 70% rally - and a stronger-than-ever relative earnings trend. Other value sectors are also in demand, though not all. A net 56% of investors expect European value stocks to outperform growth peers in the next year, with insurers and banks among big overweight. Yet autos, the cheapest sector in Europe, remain deeply unfavored.
  • Given economic risks, cyclicals are an area that investors remain wary of, despite steep recent declines. While their valuations might look appealing at first glance, they would refrain from buying them back at this stage. In the past, the relative performance of cyclicals bottomed on average one month after a PMI trough, and we are not there yet. In other words, “defensive” companies, such as Utilities or Healthcare which, thanks to their lower sensitivity to economic conditions, pricing power, high dividend income or low volatility, have outperformed more cyclical stocks by almost 16% (in euro) since the beginning of the year, should keep the lead.