Ongoing anxieties over rising prices and spiralling inflation are impacting consumers and stock markets alike. Many commentators have even gone so far as to say that a recession is now more or less inevitable. As far as the most recent global equity market sell-off is concerned, recently published inflation figures are behind it, and it is becoming increasingly clear that the central banks need to be more aggressive with their monetary tightening.
A number of major US companies (retailers in particular) have shared their own pessimistic predictions. If these companies are experiencing difficulties, it is most likely because they are now finding it difficult to pass on rising costs to their already-squeezed customers and consumers: surging inflation is combining with the rising cost of living, hurting households on both sides of the Atlantic (inflation hit a 40-year high of 9% in the UK and is currently at 8.3% in the US).
Governor of the Bank of England Andrew Bailey expects the CPI measure of inflation to rise further, going well beyond 10.0% by this autumn. His publicly shared predictions about the future and rising food prices have been gloomy: war in Eastern Europe, disruptions to exports from Ukraine and continuing lockdown measures in China have combined to create a decidedly “apocalyptic” state of affairs.
The increase in UK household costs has seen consumer confidence plunge to its lowest level since records began in 1974. All of this confirms just how damaging rampant inflation can be for companies, markets and investor sentiment.
Meanwhile, the EU is changing its own direction of economic travel in response to rising inflation across the Eurozone, triggered by the invasion of Ukraine. There is even talk of stagflation. Inflation there now stands at 7.5% for the second quarter of 2022, while Germany's economy has begun to contract. To add to the EU’s woes, Russia has decided to turn off the gas taps, creating energy insecurity for the whole bloc.
Ukraine, however, could well end up being a surprise ally for the future: it is now synchronised with the European electricity network and looks set to be an important partner for the European Green Deal. More than 55% of Ukraine’s electricity is produced by nuclear power plants – and this is clean energy. What's more, it can produce its own wind and solar energy.
At Investment Quorum, we know full well that the marketplace is brimming with anxieties for investors. Growth is slowing, a recession looks almost certain, stagflationary pressures are building up and there is no sign of any end to the conflict in Eastern Europe. Concerns about monetary tightening and disappointing corporate earnings are also weighing heavily on market and investor sentiment.
It is perhaps unsurprising that Wall Street's S&P 500 Index has just logged its seventh consecutive week of losses, while other global stock markets also react negatively to all the doom and gloom. But in context, all of this looks very much like a classic “growth scare”, typified by recent sharp pullbacks in those stocks most affected by slowing economic growth. Take last week’s notable profit misses in some of the US retail and technology businesses as an example.
Since the start of the pandemic, we have seen an enormous V-shaped economic recovery. This was never going to be sustainable, and the “stay-at-home winners” were always the most vulnerable to any corrections in corporate profitability. Peloton and Netflix are a couple of classic cases: their stock prices have plummeted, and they have gone from being among the most beloved companies of the pandemic to the most unloved as the economic backdrop has changed and the world has emerged from lockdown.
Disposable incomes and consumer sentiment are being slammed against the buffers by rampant inflation, war and the central banks finding themselves between a rock and a hard place regarding monetary tightening. So it is no surprise that certain financial assets (including equities) have stalled and even nosedived in certain sectors (those sensitive to periods of dwindling growth).
It must also be pointed out that the companies that were highly valued during the pandemic were actually unprofitable. They were reliant on negative real interest rates to support their rich valuations, and the result is that they have suffered most as inflation and monetary tightening have taken their toll on their business models.
It is simply impossible to pretend that these are anything other than extremely testing times for investors. But this is actually an ideal opportunity to use the current volatility and redeploy asset allocations differently. We are now in a world that will need to embrace quantitative tightening over quantitative easing, while managing higher inflation and supply problems and factoring in green issues.
On the subject of quantitative tightening, it is likely to lead to higher government bond yields and a flatter yield curve. But while quantitative tightening is not simply quantitative easing in reverse, its impact on interest rates is likely to be more muted.
These factors will most likely result in greater diversification in portfolios. They will now include cyclical sectors such as financial services, energy, industrials, basic materials and real estate. Some of these have been out of favour in recent times – higher-than-average growth rates have favoured growth industries, such as technology. It should, however, be emphasised that many quality technology businesses will continue to prosper in a world that is constantly changing on the back of technological innovation.
We have recently been tilting portfolios towards some of those more cyclical sectors, while at the same time increasing our exposure to UK and dividend income providers. This is because we believe that these will outperform non-income paying companies. What’s more, they should also help us outrun inflation. And as always, companies with true pricing power should perform better in the current economic environment.
Finally, we continue to believe that the current sell-off in global equities is “overdone”. This means that we can reasonably expect a recovery over the latter part of this year which should continue into 2023. Needless to say, one should always be mindful of downside risks – of which there are plenty. Global valuation multiples have derated to below their long-term averages, despite still low real yields. We therefore see scope for some upside surprises in a number of sectors. And this will help the equity markets extricate themselves from all the uncertainty in which they are currently mired.
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