Seven things for equity investors to bear in mind in these changing times
Headwinds arising from high inflation, rising interest rates, geopolitical risks and concerns about growth have triggered a correction in the equity markets. Although volatility has increased, significantly lower valuations offer opportunities in spite of the prevailing risks. However, a number of relevant factors should be taken into account.
The current capital market environment is fraught with uncertainty. It has become quite clear that this is because we are experiencing a period of profound upheaval. The coronavirus pandemic and the escalation of certain geopolitical tensions have accelerated some existing trends, stopped others in their tracks, and also brought forth new trends. Inevitably, this is having repercussions in the equity markets. Stocks are particularly sensitive to changes and prone to swings. The magnitude of the changes that are currently unfolding is also reflected in the shift in investment preferences and higher risk premiums. It remains to be seen where we are heading and where a new equilibrium may be found in this environment.
Currently, economic growth and inflation are the primary causes for concern. The dominant influence on market movements is uncertainty in connection with the war in Ukraine and its side effects – sanctions, shortages of products and raw materials, and soaring prices, for example for oil, gas, agricultural products and industrial metals. Europe is currently bearing the brunt of the war’s impact. At the same time, there is uncertainty about whether the central banks that have decided to raise interest rates to rein in inflation may push things too far in light of the multitude of factors that are threatening economic growth. However, Union Investment’s economists expect that inflation will soon begin to decline slowly, which should make it easier for the central banks to achieve a ‘soft landing’ that does not stall the current economic cycle.
The current market phase thus entails not only risks but also opportunities, although a patient and careful approach will be required to seize them. Profit expectations have fallen, but the private sector is still expected to see further stable growth. Pressures on supply chains persist in certain parts of the world, but Union Investment’s experts expect these to ease gradually. Provided that Russia does not cut off its supply of natural gas completely, economic growth should continue not just in the US but also in Europe, and the gap between the two regions’ pace of growth should begin to close in 2023.
In this scenario, equities would likely remain an asset class that can offer promising opportunities. But it would be prudent for investors to take account of the following seven factors in their investment strategy:
1. Duration matters, including in the equity markets:
Growth stocks performed extremely well in the last decade because their valuations were being driven up by falling interest rates. But much of the promise of growth companies rests on profits that will not be generated for a long time yet. Their stocks therefore have a long duration (capital commitment period), which makes their valuations particularly sensitive to rising interest rates. On the other hand, companies that are likely to generate predictable profits in the coming years, such as retail or energy companies, have a shorter duration and are less affected by rising interest rates. In an environment of higher nominal economic growth, the market will become significantly broader than it used to be. Revenue and profit growth will be spread across a larger pool of companies and the edge that growth companies had in the past will start to melt away.
2. Value is making a comeback:
The investment strategy spearheaded by US investors Benjamin Graham and David Dodd, which focuses on stocks that are valued favourably from a fundamental perspective, is starting to regain is former appeal. Over the long term, value stocks have historically performed slightly better than growth stocks (see chart). In terms of returns, we expect value stocks to be able to make up some of the ground they lost to growth stocks in the past ten years. Moreover, our economists believe that inflation will not return to the extremely low levels seen before the pandemic but rather remain at a permanently elevated level. This will lead to higher nominal growth, which will erode the growth premium that the markets had previously priced in, particularly for tech companies and online businesses. Growth is becoming less of a scarce commodity.
Value stocks currently have the upper hand
3. Growth is shifting to different areas:
The sun is not necessarily setting for growth stocks, but it is moving to new areas. Structural growth trends relating to topics such as digitalisation, deglobalisation, demographic change and the decarbonisation of the economy will generally remain intact. As a result, the potential for growth stocks will broaden beyond the tech sector as the sector’s marked superiority in terms of profit performance is starting to weaken. Profit growth has passed its peak and factors such as consumers’ spending decisions, investment choices, growing competitive pressure and tightening regulation are reinforcing this trend. On the other hand, digitalisation and automation trends are starting to permeate ever more sectors, for example manufacturing and healthcare. This unlocks new areas of growth. The commodities sector is also likely to be among the gainers over the long term, as it has the potential to contribute significantly to decarbonisation efforts through trends such as the growing use of electric-powered transport.
4. Quality pays off:
High-flying hype stocks such as those of exercise bike manufacturer Peloton or video conferencing software provider Zoom have suffered painful losses in recent months. By contrast, equities of companies with AA or AAA credit ratings have performed well above the market average in the year to date. The current market environment is separating the wheat from the chaff. Companies whose business models are not profitable or whose profitability is built on shaky foundations are seeing their valuations decline substantially, while companies with a robust global market position, strong customer loyalty and solid pricing power are an attractive investment proposition against the backdrop of structurally higher inflation. Such companies can be found in a wide variety of industries, from manufacturing to consumer goods (e.g. in the food sector and grocery retail sector), energy, commodities and finance.
Tough going for equities: profit growth is weakening
Waning tailwind from profits
Tough going for equities: profit growth is weakening
Valuations have normalised
5. Minimising inflation risk:
Against the backdrop of rising nominal growth and elevated inflation, equities offer more opportunities than bonds. Many innovative companies with a solid business model in qualitative terms are able to pass on rising prices to the buyers of their products and services and thus protect their margins in the face of rising costs. There are also sectors in the equity markets that perform solidly (or have at least done so historically) in an environment of elevated inflation, for example commodities, real estate, infrastructure services, and banking.
6. Valuations can create opportunities:
The losses in the bond markets triggered a repricing of equities. In recent months, even many large investors were forced to reduce risks in their portfolios by scaling back their equity exposures. This led to a correction in the equity markets that has brought valuations down significantly. Measured by the S&P 500 index, the price/earnings ratio of US blue-chip stocks currently stands at around 18, while the p/e ratio of stocks in Germany’s key DAX 40 index stands at just 1 By historical standards, these are relatively low figures. Given that growth trends remain intact, Union Investment’s experts expect companies to remain able to create economic value despite the aforementioned risks. Strict price discipline and an active, bottom-up approach driven by fundamentals should help to unlock promising opportunities. Sectors where stocks are currently trading below their fundamental value include the commodities and banking sectors.
US equity market valuations near historical average
Price/earnings ratio of the S&P 500 index
7. AAn active approach is required:
In light of the plethora of risks facing equities as well as new opportunities in this asset class, active stock-picking and careful monitoring of market movements will be crucial for investors wanting to retain their ability to act quickly if necessary. Investors should therefore rein in their expectations in terms of returns and brace for persistently elevated volatility, because valuations are no longer being supported by falling interest rates in the way that they used to be. At the same time, focusing on international enterprises with a broad-based business model should pay off. This approach will also help investors to better mitigate the impact of potential risk scenarios, such as escalation of the war in Ukraine or a fully fledged energy embargo, because these companies are less likely to focus heavily on one particular region.
As at 17 June 2022.