“If you think this has a happy ending, you haven’t been paying attention.” is a quote from Game of Thrones bad guy Ramsey Bolton, but it could easily been straight from the mouth of Federal Reserve Chairman Jerome Powell. In our last Quarterly outlook we asked for clarity on the size of rate rises and now we certainly have it. At the September Fed meeting Powell ruled out any lingering hopes of a soft landing, describing it with typical understatement as a “very challenging” prospect. Recession in the US and Europe is almost certain this winter.
At the moment the markets are rough and are recalibrating to a changing environment of higher rates and lower liquidity. In the last week of September numbers came out which have rarely be seen in the last 25 years. At the time of writing, inflation in the Netherlands was reported at almost 18%; during a few hours it was possible to make some 40% in UK gilts; spending on mortgage payments for an average American family has even spiked up to levels last seen in the early eighties.
A rapid rise in interest rates, energy prices and the dollar is usually not a good cocktail for stock prices. The markets have adjusted lower since March with the S&P 500 down 25% by the end of September from its peak at the end of 2021, and investment grade credits down by about 15%. So far this year US bond and equity markets have seen a drawdown of more than USD 55 trillion from their recent peak. This wealth effect is reflected in consumer confidence. October is often a month when bear markets reach their nadir. However, even with the current decline behind us, our outlook for global equities remains cautious. Increasing financing costs combined with rising input costs and the threat of lower consumption puts pressure on corporate profitability. Shrinking market liquidity brings multiple expansion to a halt.
With regards to emerging markets for the coming quarter, we maintain our five factor scores as they are. It’s important to note that central banks in many emerging countries have been tightening for a long time already, while the Fed is far from finished and the ECB in Frankfurt has only just started to raise interest rates. So, less inflation comes with potentially fewer interest rate hikes in the emerging world. The outlook for emerging markets is therefore significantly better from the point of view of inflation and interest rates than in developed markets.
So what’s a constructive way forward for equity investors?
The central line in the approach of our teams is that they focus on solid businesses with good earnings potential and strong cash generation, which can be bought at appealing valuations. Not just cheap stocks, but healthy stocks which will do well over a period longer than just an occasional quarter. We do not take a punt on the current macro events, but will factor in the consequences of a changing macro environment for our portfolio companies’ prospects. Companies with pricing power that aren’t over-leveraged, now available at much lower prices, are preferred. These value-oriented stocks will likely provide protection from inflation and have a good chance to outperform in this environment. We are positioning our portfolios to reflect that higher-than-average inflation could last for some time. One sector of particular interest is healthcare and with its recurring revenues it is widely considered to be more recession-proof than other sectors. We also continue to find high-quality companies in two favored sectors, technology and financials, where we have high exposure. Though current markets are challenging, this is also a time of opportunity for stock picking.