It’s all about time

After a disastrous first half and while the economic scenario in developed countries is deteriorating, caution would encourage exiting risk assets in anticipation of a lull. But is caution always good counsel?

Laurent Denis, Director of Investments

Time is of the essence in the stock markets

Laurent Denise

Fears that advanced economies are slipping into recession have been heightened recently by the US manufacturing ISM at 53 (56.1 in May), hurt by a drop in new orders and employment. As for stock markets, the S&P and European indexes are down about 20% year-to-date. So after this significant drop, the question is whether the market is sufficiently rewarding risk today.

In the USA, we assign a 40% probability of a recession (30% mild recession, 10% severe recession) and a 60% probability of an economic slowdown over the next 12 months. In a scenario that avoids a recession, we believe the market has strong capacity to recover. Let’s look at the earnings trend for the next 12 months.

We have already noted that the rate of return in the US is extremely high and will decrease over time. However, we believe that these adjustments will not happen as quickly as investors currently expect. Indeed, in the long term, the evolution of the results of the companies included in the S&P500 mainly depends on the information technology sector. However, the technology sector is now dominated by natural monopolies – companies that benefit from network effects and significant economies of scale. Tighter regulation will loosen their control over time, but this is likely to be a slow process.

Also, over the long term, the trend in earnings growth outside the technology sector is less impressive. The economic slowdown is accompanied by falling prices for industrial and agricultural raw materials, allowing companies in defense sectors with solid gross margins, such as agri-food or beverage, to maintain reasonable margins. On the other hand, it is true that companies in sectors with low gross margins, such as distribution or manufacturing of construction materials, face the double challenge of managing limited pricing and likely falling volumes.

Overall, the profitability of US companies in the S&P500 is expected to decline but remain at an acceptable level over the next 12 months.

In Europe, the fall of the euro clearly supports exports and will limit the fall in profits in the second quarter. The decline is likely to be felt in the third quarter. But even here, the worst is not yet known, as companies confirm a full backlog of orders at the moment and a strong ability to adjust their prices to largely offset resource inflation. Possible social unrest and rising wages should be expected, but the effects will be felt only later or even in 2023. The situation in Ukraine remains the main risk for Europe. Stopping or continuing to cut gas supplies may call into question the evolution of companies’ profits.

In summary, we see that valuations in stock markets are starting to factor in high stress scenarios. If it is too early to change the position significantly, the entry point is already close.

It’s still a little early for credit

High yield spreads mean the market expects a default of 7-8% over the next 12 months. In the worst case, the rating agency Moody’s estimates it at 6%. In March 2020, the market estimated it at 12%. Part of the risk, then, clearly lies in the prices. It should be noted that currently the absolute rate of return exceeds 7.50%. However, historically, at this level, the probability of a positive return over the next 12 months is over 80%. Furthermore, the 7.5% rate generates enough carry to support an additional widening of spreads of around 250 basis points…that is, the highs reached 2 years ago.

In conclusion, we believe that the high yield market needs a final capitulation so that the last weak hands (opportunistic buyers) are replaced by investors with a more strategic view. It will then achieve a sufficient risk premium to stabilize and return to healthy fundamentals.

Close to entry points

At the beginning of July, we are a little more constructive. Of course, macroeconomic indicators are not good news, but the divergence of monetary and fiscal policies in China and Japan should limit the slowdown in global growth. The resilience of societies is amazing. But the stability of the consumer will be tested more. Even if the savings are significant, the least favored categories and the broadest sections of the population suffer from a significant drop in their purchasing power. Storm or storm for consumption? Hard to tell.

However, we are approaching an entry point in both the equity and high yield markets. Of course, the risks remain, but the compensation already partly reflects many uncertainties. The low liquidity of the summer months can cause mini market shocks that will be used for more significant repositioning.

In the meantime, we wish you a good summer.

07/22/2022.  Our current beliefs by asset class

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The opinions expressed in this document correspond to the market expectations of ODDO BHF ASSET MANAGEMENT SAS at the time of publication of the document. They may change depending on market conditions and cannot in any way be the contractual responsibility of ODDO BHF AM SAS. We remind you that past performances do not predict future performances and are not constant over time. Before investing in any asset class, potential investors are strongly advised to learn in detail the risks to which those asset classes are exposed, including the risk of capital loss. The investment must be made in accordance with the investment objectives, investment horizon and ability to withstand the risk associated with the transaction.