Research Note | Markets are transitioning from growth to value

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    Markets are transitioning from growth to value
    Markets are transitioning from growth to value
    07 February 2022

    Key Highlights

    • Turbulent equity markets globally as world enters mid-cycle expansion phase
    • Perfect storm of geopolitical tensions, rising rates and lower earnings growth
    • High-flying growth stocks are being sold off as investors seek to de-risk

    Investors at the ready

    The start of 2022 marks a deep conflict between the known and the unknown. We are all familiar with how normal economic cycles unfold – typically from boom to bust within an average of seven years. But the pandemic years of 2020 to 2022 have hardly been typical. From market crash to market recovery, the journey has been one of extremes.

    Now as we enter the third year of the Covid pandemic - or even the Covid endemic – market analysts are asking themselves, will normal rules apply, or should we put aside all standard assumptions? The answer of course lies somewhere in between, and the prevailing strategy seems to be to proceed as normal, while staying extra vigilant and front-footed.

    Opposing forces

    This goes some way to explaining the jumpy markets seen over the last couple of weeks. On the one hand, investors are buoyed by the fact that most global economies grew unusually strongly in 2021. The US’s GDP growth last year reached 5.7 percent, the strongest in nearly four decades, while the EU’s is expected to be 5 percent, better than previously expected. The fact that this global economic recovery is only 18 months old suggests that there is room for it to broaden further.

    On the other hand, investors are becoming increasing nervous for several reasons. The US Fed has all-but-confirmed that the first post-outbreak rate hike will be in March, with possibly three, but as many as four, more hikes during the course of 2022, depending on whether the current runaway inflation can be contained. While the early round of rate hikes do not automatically translate into weaker equity markets, there are more uncertainties surrounding this rate hike cycle than most.

    Additionally, maybe because markets were so focused on rising rates, it is only in the past few weeks that they have started to actively factor in the deepening Russian-Ukrainian crisis. The latest spike in oil, gas and metal prices has brought attention to not just the short term, but also the long term ramifications of a potential conflict. Even if US military intervention can be avoided, economic sanctions could further intensify oil price rises, shortages of agricultural commodities and supply chain disruptions.

    And thirdly, assuming that tensions with Russia do not escalate severely, it is reasonable to expect sustained but slower economic growth. The International Monetary Fund (IMF) is forecasting the US economy to grow by 4 percent this year. This slowdown, while relatively minor, could flow through into softer corporate earnings and profit margins especially if inflation remains high.

    Be sector-discerning

    Given these worries, it is perhaps surprising that markets have not reacted more negatively. In fact, the underlying market sentiment appears to be one of optimism that economies will continue to expand as the world returns to post-pandemic normality. Amid what we characterise as a “mid-cycle expansion”, we would agree that global growth will moderate in 2022 but still present solid investment opportunities.

    Within equity markets however, we note that there will likely be lower tolerance for very high risk assets. This particularly applies to sectors that are seen to have elevated valuations, such as the “long duration” growth and technology stocks. These stocks are termed long duration because they are expected to deliver a majority of their cash flows only in the distant future.

    Until recently, these stocks were able to garner significant investor interest given their potential to benefit from the Covid-induced demand for digital and contactless solutions. But they started to correct towards the end of 2021 and have fallen by more than 10 percent.

    Figure 1: Elevated valuations of US technology sector
    S&P 500 Tech Next Twelve Months Price-Earnings Ratio (NTM P/E), Dec-2021

    Elevated valuations of US technology sector S&P 500 Tech Next Twelve Months Price-Earnings Ratio (NTM P/E), Dec-2021

    Source: Credit Suisse, 31 Dec, 2021

     

    In our view, these high-flying large and mega-cap growth sectors will continue to be vulnerable. Given that their earnings are derived from future years, they tend to be particularly sensitive to interest rate raises. In an environment of monetary normalisation, not just in the US but around the world, such stocks are likely to come under increased pressure.

    From growth to value

    Looking ahead, while there will no doubt be some buying on dips, it is hard to see that the tight lockdowns put in place to control Covid infections will recur. Without this stay-at-home factor acting as a tailwind for long duration growth stocks, and the ending of easy money, current valuations look unsustainable.

    Instead, a mid-cycle expansion phase tends to favour:

    1. Cyclical risk assets. These are “old economy” sectors such as banks and basic materials, and in this environment are likely to be even more attractive if they are trading below market valuations
    2. Real assets. These are physical assets that have intrinsic value such as real estate, infrastructure and commodities. Given the ESG (environmental, social and governance) factors in play across the investments landscape, this is an important criteria particularly within this sector
    3. Alternatives. This becomes particularly relevant at a time of market stress, such as a rate hike cycle, when investors are seeking diversification beyond traditional assets classes.

    This is supported by market behaviour so far. Broad equity assets have not been subject to significant market sell-offs and investor exposure remains high compared to previous periods of rising rates such as 2018. Similarly, corporate credit spreads relative to government bonds have risen, but only slightly. These signs suggest that while investors are starting to rotate away from their riskiest assets, they are not shying off risk altogether.

     

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