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Navigating a market in transition

MONTHLY INVESTMENT BRIEF

OCTOBER 2021

 

Laurent Denize

Laurent Denize,
GLOBAL CIO

Our conviction is that this is not (yet) the time to move to a pure rotation from "Growth" to "Value"

After a record reporting season for the second quarter of 2021 – the best in 10 years – what can we expect from companies’ earnings prospects in an environment that is becoming a little less favourable? On top of the factors that are well known – growth that has peaked in several parts of the world, bottlenecks, bankruptcies of real- estate companies in China – the recent spike in energy prices may cast doubt on companies’ ability to keep their margins so high.

What does the consensus say?

In 2021, five sectors accounted for about 75% of growth in global EPS (earnings per share): energy, banking, mining, autos and consumer goods. The consensus of analysts have lowered their 2022 EPS growth forecasts from +17% at the start of the year to +7/8% currently in the case of European companies. This reflects negative base effects but also a highly cautious view of the recent increase in input prices.

What are the main factors influencing results?

  1. Growth: The main downside risk is in China, with its dual shift towards greater regulation (i.e., a state-led reallocation of capital) and redistribution (“common prosperity”). China possesses many sources of leverage for preventing harmful fallout from an Evergrande bankruptcy, but its new “growth model” that is less dependent on corporate and real-estate debt will, at least in the short term, provide less momentum to global growth.
  2. Inflation: Some bottlenecks have lasted longer than initially expected. Shortages have now extended to energy supplies in several regions, including Europe and China. The most extreme case is the UK, which has seen panic buying of petrol, leading to the closing of service stations, which has only worsened the shortages. The energy squeeze is creating downside risks to economic activity, upside risks to inflation, and political risks (including the politization of the inflation risk). Even so, we do not share the stagflation scenario being bandied about by some commentators. We believe that, yes, growth will weaken, but from extremely high levels. Clearly, central banks are more nervous than they were at the start of the year, and the risk of “monetary error” is rising.
  3. The euro, which had been a headwind for European companies, is now a tailwind, as about 50% of listed European companies’ revenues come from abroad. The euro’s recent weakness is therefore good news and will ultimately have a positive impact on the most export-intensive companies.
  4. Pricing power: Companies able to pass on higher input prices, particularly raw material prices, to their customers will continue to see growth in their earnings series. And it’s true that analysts’ revisions of 12-month forward EBIT (earnings before interest and taxes) have shifted in favour of companies with high pricing power. Keep in mind that such companies’ stocks have outperformed their peers by about 20% on average over the past year, and that their two-year relative P/Es are trading at a 7% discount to their 10-year average.
  5. Earnings and margins: After record earnings and margins, there is now a risk of seeing momentum deteriorate – for several reasons. The index for which we have the most data is, obviously, the S&P. There are some sectors that call for caution, notably the hardware sector given a decline in CTOs’ planned spending on IT equipment and rising inventory levels. Second, over the past three months, wages have soared by an annualised 35% in air freight and logistics and by 15% at restaurants. Even so, dispersion is extremely wide, as average wage growth is still only 4% for S&P companies. But the trend is clearly upward. Third, tax reform could lead to a downward revision of about 5% in S&P 500 earnings per share forecasts for 2022. This is less than expected, given the delay in implementation. However, initial results confirm the companies’ ability to raise prices higher than the rise in their costs, thus allowing them to hold onto their margins. The question is, for how much longer? Caution is thus the watchword, with high valuations allowing for some unpleasant surprises.

What is the best possible positioning in this context?

Once the pandemic and bottlenecks recede, companies will be less able to raise their prices on the grounds of “shortages”. The real test is still ahead, with, on the one hand, players who create added value recognised by customers and, on the other hand, companies that suffer from the rising cost of raw materials with no flexibility on sale prices.

In Europe, we are more optimistic than the consensus for 2022. Nominal GDP growth, weighted by the countries with which European companies trade, could be +8% in 2022. We therefore believe that this operating leverage is being underestimated.

Against this backdrop, we are overweighting banks, pharmas, autos and, for investors who are less focused on ESG criteria (which are rather central for us), energy. We are steering clear of heavily regulated utility-type companies, as well as luxury goods and techs, which are overexposed, respectively, to China and higher interest rates.

After numerous false starts, rotation is in progress. Don’t miss out!

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