Investment Environment July 2022

01.08.22

Introduction

July has been a better month for equity markets with a positive return seen across most markets, although macro headwinds persist and volatility remains high. Globally, inflation continues to cause concern with the US inflation reaching 9.1%, SA hitting 7.4% and the UK experiencing the highest at 9.4%. In response, central banks continue with aggressive rate hikes led by the Fed increasing in line with expectations of 75bps. In South Africa the MPC surprised the market with a 75bps hike where the market was expecting a 50bps increase. This coupled with the war in Ukraine, and a continuing energy crisis in Europe, makes for a tough macro environment. However, a lot of this bad news has already been built into the pricing of the market and as we are seeing with earnings season in the US, companies that are able to reflect some growth and maintain strong fundamentals are being rewarded. We expect volatility to remain but there are some positive signals from a number of our preferred stocks indicating an improved appetite for cautiously re-entering the market. We are monitoring this closely and positioning our clients’ portfolios accordingly.

Macro Environment

The macro environment remains unfriendly to investments with rising rates and inflation. Challenges exist globally but there is some optimism that US inflation has peaked as the base effect of an increased oil price should come through in August numbers. There is increasing concern about growth and the US entered into a technical recession (two consecutive quarters of negative GDP growth) in July. Although meeting the technical definition of recession, at present it won’t be classified as a recession due to the strong labour market. Ukraine continues to take pain from Russia’s invasion with crippling effects on both economies. A UN-brokered deal might see grain exports from the Black Sea region resuming which should assist in alleviating global food shortages. The energy crisis in Europe is creating concern for winter as the Nord stream gas line is operating at 20% requiring countries such as Germany to curb energy use despite being in the middle of summer.

Sales of new houses in the US dropped significantly in June reaching a two year low. As mortgage rates climb and the general cost of living is increasing there are fewer buyers in the market, which is slowing demand for new homes (new builds and developments). Interestingly, the price of existing homes continues to rise, which could push buyers to the new home category. As outlined by the Statista chart there has been a very clear slow-down in volumes and price. This is an indicator of a slowing economy and should assist in taming inflation in the months to come. The question remains if the Fed has over done it with very aggressive hikes and the longer-term impact that has on the consumer and in turn the growth prospects for 2023 and beyond.

Inflation remains critical to the macroeconomic discussion as it sits at record highs globally. The Fed has made it clear to markets that rate hikes will continue as they need to see inflation come down. However, clear guidance cannot be given by the Fed and they will need to be guided by the data points as they develop. Market commentators are unsure whether the September hike could present another 75bps or might move back to 50bps. This makes the August inflation number an important data point for markets. Some participants are hopeful that the Fed will loosen conditions as early as next year. At Douglas Investments (DI), we still feel there is a lot of uncertainty to unpack in the coming months and it will be important to make decisions from a cautious footing. The chart re-emphasizes how quickly inflation has accelerated in the last year. When looking over a 10-year period the steep acceleration compared to history becomes very apparent and the reason it is so important to tame it soon.

The macro environment is still complex with a lot of differing opinions across participants. Some participants believe that the Fed will pivot next year and start cutting, which will be good for growth whereas others feel there is still a lot of pain ahead as growth slows and inflation remains. This sort of environment means volatility will remain and we can expect big moves on news flow. DI is of the view that the macro environment is still difficult; however, there are certain stocks and themes that have been unduly punished by the market and therefore present buying opportunities as they evidence their ability to produce strong results despite the macro headwinds. We have addressed this point in a number of previous Investment Environments and can now see it with second quarter results.

Equities

July was a green month for markets as investors jumped onto some better than expected earnings and rewarded companies that showed growth close to or above expectations. The S&P500 ended the month up 8.99%. The JSE saw upside of 4.98%. The FTSE  saw a gain of 3.75%. The chart depicts the market movements for the YTD 2022 with the light blue line showing the JSE all share (down 6.5%), the blue line showing the FTSE 100 (up 0.6%) and the orange line showing the S&P500 (down 13.3%) after the July rally.

In previous months we have unpacked how significantly the PE multiple has come off for a number of our preferred stocks showing a significant derating. The big question that needed to be addressed to determine whether this presented a buying opportunity was how would the “E” (earnings) part of the multiple hold up. If earnings dropped off significantly, then you would see the PE increase, meaning companies are facing pressures and there isn’t a clear buying opportunity. However, should earnings maintain a positive trajectory then the valuations appear cheaper and make an attractive entry point.

What we have seen with the second quarter earnings season thus far has represented a mixed bag. Certain companies have come in close to, or even above, analysts estimates, which has been a very positive result as the market had priced in significant earnings contraction. Other companies have seen large earnings misses which the market has punished. In general, the market has priced in a lot of negative expectations so where there are positive results from a company we have seen strong price movement which aligns to our thesis in previous Investment Environments. The table looks at the results of some of our preferred stocks as well as some stocks that missed the mark to unpack our views going forward as we sit in a stock pickers market.

From this table it is clear that although companies are able to grow the top line there is definite pressure on the bottom line, which is in line with the various macro headwinds and the rising interest rate environment. Furthermore, the market has priced in significant downside and negative sentiment which has allowed companies that are reflecting results close to market expectations and a positive outlook to receive affirmative market reactions. Although many stocks saw a more positive end to July based on earnings there is still uncertainty and concern in the market despite participants hoping for a positive turn. Our view is that those companies with strong fundamentals are proving that they can operate in a tough environment, and have a track record through the cycles, thereby still delivering results that are rewarded by the market. A number of these companies have seen a sell off to levels below their 10-year average making them attractive from a valuation perspective. However, we still maintain the view that a number of companies are going to be under significant pressure and we are expecting further sell off as negative results come through. In this environment picking specific stocks through detailed research and analysis and a skeptical approach is critical as we are seeing a big divergence in performance amongst companies that are even in the same sector.  At DI, we are not rushing back into the general market but where appropriate we are assessing entry points for specific companies for our clients through detailed company research and a long-term outlook.

The general trend of earnings guidance has reflected a slow down in growth, with analysts decreasing the median EPS estimates for Q3 by 2.5%. As outlined by the chart from FactSet only the energy and utilities sector have seen earnings upgrades for the third quarter whereas the remaining sectors have seen a revision downwards with the largest impact coming through in communication services. This is indicative of the pressure coming through the system and ultimately affecting the consumer. Although earnings is still expected to grow it will likely be at a slower rate.

As further earnings come through for the second quarter as well as guidance for Q3 we will get insights into the impact of the macro environment on both companies and the consumer. At DI, we believe companies with strong cash flow generation and a healthy balance sheet will hold up well but certain growth stocks with a long term earnings growth may remain out of favour with the market until the outlook becomes more certain. Stocks in the energy sector are expected to continue pulling the index up with elevated oil prices resulting in positive earnings growth and cash flow generation. The extent of the pressure being faced by the consumer is still being debated and will be important in the coming months as the knock-on effect to companies’ earnings and margins will be significant.  

The charts show how the strong end to July has seen the S&P500 PE tick upwards. The bottom chart compares the forward PE to the 10-year and 5-year average with the current forward PE moving to slightly above the 10-year average but still significantly below the 5-year average. The top chart compares the forward PE to forward change in earnings with PE moving upwards while earnings have come off. Although this chart reflects the index which is skewed by the likes of the energy sector this trend is what we are monitoring and have emphasized over the past few months to assess attractive buying opportunities.

With the US moving into a technical recession the big question remains as to whether the NBER (National Bureau of Economics Research) will declare it as such. The NBER is what economists look to define as a recession and many market participants would consider an actual recession. It is clear that the US (and many other countries) are facing economic stress. However, there are some key differences in the current state of the US economy compared to the Great Financial Crisis of 2008 and what followed. Some of the differences are summarized below: 

  • Inflation – as the main headline driver in recent months it is no surprise with it sitting at decade highs that it is a key difference from the 2008 crisis.
  • Employment – the US unemployment rate is 3.6% which is far lower than during the crisis
  • Consumer Confidence – Consumer confidence is very low at the moment but other measures of consumer health such as defaults are nowhere near the levels seen post the 2008 crisis
  • Housing – The 2008 crash is well known for the steep collapse in house prices which despite some weakness in this environment there is no current threat of a crash
  • Industrial production – At the beginning of 2008 industrial production fell steeply but is currently seeing growth.

The chance of a recession is still very real, with a number of economists believing it is inevitable. The strong labour market is holding it up at the moment but as the Fed continues to hike and the economy slows, unemployment will rise. Although the market took hope from Chairman Powell’s recent speech it is our view that it would be too early to be looking to dovish sentiments and further steep hikes are expected meaning the likelihood of a recession is elevated. August data points will be important to provide guidance on whether the hiking cycle could still result in a soft landing or if the most likely outcome is a recession. The hope is that even if a recession manifests, it will be a short, shallow one.

Conclusion

There is no doubt July was one of the few positive months of 2022 and companies with good fundamentals are showing they can still produce strong results despite the difficult operating environment. Valuations have priced in a lot of negative news so where there is positive upside we can expect some price uplift. Despite this, the general environment remains difficult, and we believe a cautious approach should be maintained. We are frequently reviewing client portfolios and ensuring that they are positioned appropriately for this environment. Most clients hold high cash levels which could be utilised to take advantage of the de-rating of certain companies, which is being done strategically, although we remain cautious on the general market as further volatility and potential downside is expected.

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