As we move past one of the most volatile quarters over the last 2 years, it makes sense to take stock of where we are headed. Surge in commodity prices, inflation, war, Fed hikes, inverted yield curve etc. have remained top of mind for investors. However, as we head straight into the Q1 earnings season in the US, it is best to take stock of various equity markets and our view on the asset class.
It is a well know observation both from historical studies and empirical data that equity markets don’t die of old age or simply due to high valuations. If we look at some of the indicators pointed out by bears, i.e. hawkish Fed, rising commodity prices, slowing growth & earnings and an inverted yield curve; it does merit caution. However, let’s look at a few key data points.
A. Leading indicators of growth, e.g. PMIs, continue to be quite strong. US composite PMI (prelim) printed 58.5 in March while Euro Area Composite PMI at 54.5, was also quite resilient and firmly in expansion territory. OECD estimates for world GDP growth for 2022 are still north of 4% and for 2023 around 3%. While certain indicators like consumer sentiment are flashing recessionary warnings, there are still quite a few that are far from recessionary levels.
B. If we turn attention to valuations, forward price-to-earnings multiples across major markets do not look stretched to us (chart), indicating a lack of euphoria. Such levels of valuations are normally characteristic of mid-to-high single digit or even low double-digit returns in equities over the next 12 months. In fact, European and UK indices are already reflecting quite a bit of pessimism.
C. We do observe a bit of slowdown in earnings growth across major markets, from the unsustainably high levels observed last year. However, over the last 1-month (post start of the war), EPS for the current fiscal year has been revised up across most developed markets and a few emerging markets (chart).
D. There has been a lot of talk about the yield curve inversion as a recession predictor. While we completely agree with that observation, we would note that equity rally tends to continue for some time after the curve (2Y10Y) inverts and before the recession hits. E.g. if we look at the last 25 years, the curve inverted thrice. In 2000, the market crashed 7 months after the curve first inverted during which time, equity markets went up ~9%. In 2006-07, the market crashed 18 months after the curve first inverted during which time, equity markets went up ~26%. Similarly in 2019-20, the market crashed 6 months after the curve first inverted during which time, equity markets went up ~19%. Each time, if an investor had de-risked their portfolio right after the first sign of inversion, they would have missed out on handsome returns.
As such, we are firm believers in the “stay invested” approach. However, we are clearly in the latter innings of this cycle, where growth is likely to slow down and investors must position their portfolios accordingly. This means avoid small caps, high yield, lower quality and leveraged investments and rather focus on high quality, mega cap and simple exposures that are less rewarding but also less risky.
Within equities, we like the US market (via ETFs) but want to be selective in EM (via active funds). We think Europe struggles from here as they try to become less dependent on Russian energy. At the sector level, we still like mega-cap and quality tech as we believe those pockets do well in a slowing growth setup. Within value cyclicals, we like energy due to the upside in commodities as well as financials on a tactical basis (next 2-3m), simply because it adds rising rates exposure which might be helpful from a portfolio perspective. The important thing is no one knows because we are trying to make sense of too many moving pieces and force-fit within a trend, when what we have seen is an unprecedented shock. We are keeping our eyes and minds open and constantly looking for things that challenge our thesis – key is to remain nimble and disciplined!
By
Ankit Agrawal
April 8, 2022
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We are licensed in Singapore, Hong Kong and India. Kristal Advisors (SG) Pte. Ltd. presently operates under the CMS license by the Monetary Authority of Singapore (MAS). Kristal Advisors (HK) Ltd is licensed and regulated by the Securities and Futures Commission (SFC) to carry out Type 4 and Type 9 regulated activities and is not involved in the discretionary management of any collective investment scheme. Kristal Advisors Private Ltd. presently operates as a Registered Investment Advisor under the jurisdiction of the Securities and Exchange Board of India (SEBI).
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