Uncertainty remains

European equities: Deep economic impact for natural gas and agricultural products

For the second month in a row, global equity markets suffered. In the first half of February, investors were mainly focused on the pace of rate increases in the US and Europe. Given the accelerating inflation data, the markets were discounting a much more aggressive stance from the Central Banks. In the second half of the month, the conflict in Ukraine was the main topic. It is a tragedy for the Ukrainian population and will also have a deep economic impact, especially for Europe. As Russia and Ukraine are important suppliers of natural gas and agricultural products, any setback in the supply will immediately have a negative impact on economic growth. It is still too early to fully assess the consequences of this conflict, especially since it is unclear whether a solution is imminent or not.

Business surveys such as the flash Eurozone composite Purchasing Managers' Index (PMI) indicated an acceleration in economic momentum in Europe. Eurozone headline inflation reached its highest level on record. Despite this, more than half of the headline number is coming directly from energy inflation. At its February meeting, the ECB didn't take the potential for rate hikes this year off the table, but did suggest that a calm and gradual approach would be taken.

At the beginning of 2022, economic activity had returned to its pre-pandemic level and the omicron wave had less of an impact on activity than previous waves. Services production was only temporary affected.

Despite household confidence holding up pretty well until now, the war in Ukraine is expected to take a toll on consumers’ purchasing power through the rise in commodity prices and lingering supply chain tensions.

Government measures and accumulated savings could help cushion the erosion of household purchasing power.

If tensions on the energy market do not worsen materially, GDP could grow by 3.4% in 2022 (Eurozone).

With inflation high, the central bank’s task will prove to be a delicate balancing act but, given the risks to growth, the ECB is likely to be more cautious in shifting its monetary stance.

In terms of style performance, over the last 4 weeks, Growth stocks finally outperformed Value stocks in relative.

Regarding Cyclical vs. Defensive stocks, Defensive stocks clearly outperformed Cyclicals, except for the Energy sector, which didn’t move a lot in absolute, but was the top performer in relative terms.

In terms of sector performance, over the last 4 weeks, we can observe that Financials suffered the most, together with Consumer Discretionary. On the other hand, Energy and Health Care performed the most, again, in relative terms.

INDUSTRIALS DOWNGRADED TO NEUTRAL, ENERGY CUT UNDERWEIGHT TO NEUTRAL.

• We have upgraded Health Care on 24/02/2022 from neutral to +1. The Healthcare sector offers a very good reward: attractive, visibility of cash flows and accelerating trends. After the value growth rotation, healthcare equipment is also attractive, like pharmaceuticals.
• We have downgraded Financials on 24/02/2022, from +1 to neutral. The geopolitical situation in Ukraine can change the sentiment about ECB rate hikes. This hasa clear negative impact on the valuation of the banking sector. We could also see a more pronounced economic slowdown in Europe, which is negative for the banking sector and diversified financials. We keep the Insurance sector +1. The insurance sector is more immune, thanks to its more global footprint and annuity type of business.
• On this new Committee, 08/03/2022, we have decided to downgrade Industrials from +1 to neutral. The negative review of the macroeconomic scenario reduces our conviction on this sector. We favor Commercial Services, which are more resilient and positive solutions for the environment.
• We have also decided to cut our underweight on Energy (open at the end of January for valuation reasons) seeing the actual uncertainty regarding oil prices. We are now at neutral.
• We keep our position on Consumer Staples at +1. We are convinced of an acceleration of the EPS momentum, thanks to the repricing of input costs. Many European players are leaders globally and the sector is very attractive (based on our financial models, DCF).
• We remain negative on Consumer Discretionary. We are more specifically negative on automobile and components, as the mega-trends in the sector (electrification, autonomous driving, etc.) will require OEMs to make large investments which will weigh on their margins. There is a slowdown in short-term demand. We are also underweight in Luxury Goods, as the sector is still significantly over-owned and exposed to Russian wealth in and outside Russia.
• We keep our -1 on Utilities (negative business and tax evolution). Uncertainty of cash flows for some players due to the Russian crisis. Level of debt is very high.

US equities: markets negatively impacted by rising energy prices

US equities had a difficult month in February, as concerns surrounding the Russian invasion of Ukraine took hold.The evolution of the conflict remains uncertain and, although the direct economic impact is limited, developed markets are clearly negatively impacted by rising energy prices. Higher energy prices could result in a more persistent inflation, eating into household incomes and corporate margins. Given the lack of visibility, we are not ready to start buying the correction yet, and decided to further decrease our portfolios’ cyclicality with health care as our main conviction.

US GDP rose strongly in the fourth quarter of 2021, supported in particular by inventory building and business investments that remain well-oriented, given a reasonable capacity utilization rate (the percentage of an organization's potential output that is actually being realized) of 77.6% in January. Consumption should also remain firm, despite fading fiscal support and higher energy prices weighing on households’ purchasing power. Job creations and accumulated savings over the Covid-19 period will compensate for those negative effects and support consumption. Separately, the residential market should remain firm, despite rising home prices and mortgage rates reducing affordability. The existing construction backlog will keep residential construction on track for several strong months.

In the meantime, despite easing supply constraints since the end of 2021, tensions in the manufacturing sector will continue to hold back production, as the war between Russia and Ukraine should translate into new supply-side tensions. Despite that negative effect, the US economy seems to be well-positioned to weather the economic consequences of the war.

In this economic environment, the labor market is being described by J. Powell as “extremely tight”, justifying the coming rate hike. He will nevertheless adjust the speed of the monetary tightening to the persistence of supply-side tensions. In this context, growth in 2022 should remain moderately above trend in 2022 (3.3%) with higher inflation being the most important downside risk to our main scenario.

In the meantime, the fourth-quarter earnings season has come to an end. According to JP Morgan, earnings delivery has been better than initial consensus expectations, surprising positively by 6%. All US sectors have been posting a healthy earnings growth and consensus expectations now count on almost 9% earnings growth throughout the entire 2022 year.

As a result of the reported earnings growth and the recent market correction, valuations have become a bit more attractive, with the US 12m forwards price/earnings declining to 19, which is still above its long-term median of the past twenty years.

Cautious stance due to lack of visibility

US equities have had a rough start to the year and volatility is likely to continue for some time. We prefer to remain cautious and aren’t ready to start buying yet, as visibility on the evolution and impact of the conflict between Russia and Ukraine is extremely limited. In this context, we have downgraded our +1 on both industrials and financials to neutral. As a result, health care remains our sole sector conviction on top of an increasing importance on stock picking, while keeping in mind that reactivity will nevertheless be crucial in these rapidly evolving market circumstances.

• We have downgraded financials to neutral from +1. Although the sector can still benefit from the support of higher interest rates from a mid-term perspective, investor focus has moved towards the uncertainty created by the war between Russia and Ukraine. The sector is being penalized in this context after the strong outperformance over the past year.
• We have also downgraded industrials to neutral from +1. With a Federal Reserve starting a new hike cycle and increasing input prices, and thus margin pressures, the sector is at risk from a short-term perspective. However, we still keep a bias towards industrials enabling the energy transition from fossil fuels to renewable energy sources. The Ukrainian situation has resulted in a jump in energy prices and an increased search for more energy independency, accentuating the importance of the energy transition. This will lead to an accelerated substitution of fossil fuels, energy efficiency investments and increased capex, amongst other renewables and hydrogen.
• We keep our +1 on the health care sector. The healthcare sector is expected to provide some stability in the current volatility. The absence of a negative impact from the Russia-Ukraine conflict, its defensive qualities, the low dependence on economic conditions and the advancing innovation in all health care segments stand out in this environment. For us, health care is clearly a GARP sector with positive earnings and an attractive valuation.
• We keep our neutral grade on consumer Together with health care, this is a more defensive sector that tends to outperform during market turmoil, although rising input prices might also negatively impact corporate margins.
• We have maintained our neutral view on technology, as we await the bottoming-out of the sector. From a short-term perspective, it is still too soon to start buying. From a mid-term perspective, we still see value in the technology sector that isn’t overly expensive. The sector continues to benefit from sequential economic growth, a slight cyclical aspect and the strong importance of innovative technology in many other sectors. In addition, several sub-segments, such as semiconductors, will benefit from a lengthened cycle on the back of the current shortages.

Emerging Markets: A balanced approach for the Emerging Markets

After January’s relative outperformance, MSCI EM faced yet another volatile month in February. This time, it was geopolitical conflict between Russia and Ukraine, evolving into a fully-fledged invasion, that led MSCI EM to correct by 3.1% (for all performances in this section in USD terms) for the month.

The impact of the Russia-Ukraine conflict and the resulting economic sanctions was most visibly felt on energy and commodity markets, with oil ending the month above $100/bbl and most major commodities from wheat to aluminium rising significantly over the month. While inflation was already running high in previous months, high commodity and energy prices raised further concerns about the inflationary impact on demand and growth. In a risk-off sentiment, treasuries gained with the 10-year US Treasury yield falling from 2% at one point during the month to 1.83% at the end of the month.

The risk-off sentiment was clearly visible in the EM sector and regional performance as well. With commodities rising, commodity exporters in Brazil (+4.6% in USD), ASEAN and South Africa (+4.2% in USD) fared well during the month. Asia underperformed as regulatory tightening in China returned to the forefront and concerns around inflation on rising oil prices dragged Indian markets lower (-4.4% in USD returns). Taiwan and Korea ended the month at -2.7% and +1% respectively as prospects of global growth were revised in light of the ongoing conflict.

Other regions that suffered severe correction during the month were Russia and Eastern Europe, being at the centre of geopolitical conflict. Russian equities nosedived as economic sanctions saw investors dumping Russian holdings.

In sector performance terms, only materials and industrials ended in positive territory, with staples holding flattish while the rest experienced a broad-based correction.

Changes to Regional views:

Downgrade India to UW (-1):

Downgrade driven by concerns on extended valuation and risk from inflation, especially in a rising energy price environment.

Downgrade Taiwan to UW (-1)

Expectation of easing semiconductor supply constraints with upcoming capacities and slowing demand momentum drives our cautious view on Taiwan. We lower our preference for the region from Neutral to Underweight.

Upgrade ASEAN to OW (+1):

Contrary to past economic cycles, major ASEAN (South East Asian) economies are better positioned from a macro perspective, and can be considered safe havens from a geopolitical perspective. They are the beneficiary of supply chain diversification efforts with an additional upside of full economic reopening.

Regions with Positive view:

LATAM: Upgrade to OW (+1) – We see the region as a beneficiary of rising commodity prices and a safe haven with regards to ongoing geopolitical risks in Eastern Europe.

Mexico: Keep our Positive view:

Region expected to continue to benefit from US recovery, supply chain diversification, etc. We maintain our positive view, but still remain selective.

Brazil: Maintain OW +1:

In a rising commodity environment, we are positive on the Brazil market, as one of many commodity exporters benefiting from higher broader commodity prices from wheat to oil. Following a sharp sell-off in Brazil equities last year, we are seeing signs of recovery in the market as valuations become attractive. Central bank rate tightening, which started last year, could eventually slow moving forward as peak inflation concerns dwindle.

Regions with Neutral view:

CHINA: Maintain Neutral –

Our neutral instance on China remains unchanged, as we wait to see clearer signals of broader monetary support and credit easing. China has laid a target to achieve 5.5% GDP growth for the year, which could necessitate some selective stimulus to the economy. We prefer names that have no risk of regulatory adversities and prefer domestic consumption names that are less likely to suffer in case of sanctions risk.

Unabated signs of consumption slowdown hold us from taking a more positive stance on the region. We also await more evidence of diminishing regulatory tightness before turning more positive. While expectations of monetary support and credit easing are gradually building, it is likely to be targeted support. China continues to maintain strict zero-tolerance measures to control Covid resurgence risks, which remain an overhang on economic recovery.

South Korea: Maintain Neutral – We maintain our neutral instance on S Korea, given the region’s strong correlation to global growth and exports, which might be questioned for peaking. Upcoming political elections could also add to market volatility. A recovery in the memory semiconductor dynamics, however, could bode positively for index heavyweights.

EM EMEA Maintain Neutral:

We are cautious on Eastern Europe, in view of the ongoing regional conflict in Ukraine. We have no investment in Russia and do not view the region as investable in the current environment.

We are positive, however, on South Africa, as we see the region as a beneficiary of higher commodities demand and a macro-economic recovery play.

No changes for the month in sector ratings:

Even before the outbreak of the Russia/Ukraine conflict we were cautious in our outlook for EM equities, in light of the fact that the Fed and other central banks had indicated tighter monetary conditions to tackle inflationary concerns. With the onset of the conflict, some participants anticipate a more relaxed tightening stance from the Fed. We believe it is still too early to make that call, as inflation concerns are only being heightened by record-high energy and commodity prices. For emerging markets, while remaining cautious, we do not believe there is particular cause for concern, either from an inflationary perspective or from tightening, as many EM central banks (e.g. South Korea and Brazil) have already prepared for a tightening cycle, while others have built sufficient forex reserves to cushion against capital-flow reversals. If anything, China has indicated early signs of being ready to ease social credit and financing conditions to boost consumption if needed.

At the same time, a higher commodity price environment is even supportive to a number of EM regions, including Brazil, South Africa and parts of ASEAN. We continue to find interesting opportunities in these regions to tackle concerns over inflation. We have also added to some defensive positions in view of heightened geopolitical uncertainty.

Overall, the positioning of the portfolio is still very much balanced – a combination of structural growth (and reasonably priced) stories in EM, with thematic tailwinds and relative resilience to geopolitical or inflationary concerns.