Are equity investors being adequately compensated for risk?
Rising inflation and interest rates have created a headwind for equities, and a plethora of near-term challenges, such as geo-political risks, a downturn in China’s property market, and potentially ‘unhelpful’ fiscal support reminds us that we are investing in a period of heightened uncertainty. We asked our panellists whether investors are currently being adequately compensated for risk, and which regions and sectors currently present the best investment opportunities.
This discussion is an excerpt from LGT Crestone’s most recent investment forum, you can access the full report attached below in this wire.
How should investors be positioned in equities for the next 12 months?
With Fed Chair Powell commenting that the Fed needs to bring inflation under control, Scott Haslem, Chief Investment Officer at LGT Crestone, feels that this means there will need to be a sustained period of below-trend growth. He assumes this means a period of weak corporate earnings.
Katie Petering, Head of Product Strategy at BlackRock Australia, said that BlackRock feels the S&P 500 index has further to fall and that investors are not being compensated for equity market risk—particularly for developed market equities, an area where they are underweight.
“There is a relationship between ISM Manufacturing PMIs [purchasing manager indices] and S&P 500 earnings revisions. Key new order leading indicators showed the sharpest contraction since the COVID-19 shock. Earnings revisions are turning lower—but BlackRock thinks there is further to go as Q3 earnings season starts next week.”
BlackRock is expecting lower earnings and revisions to unfold and feels that over the next six months investors will be better compensated in areas such as credit. It is underweight equities on a three to six-month view.
Mick Dillon, Portfolio Manager at Brown Advisory, feels semi-conductor companies are a great indicator of the underlying economy. He feels there is a quick readjustment taking place in earnings.
“Companies are seeing pressure in the supply chain and cost of goods sold. There is also pressure in labour markets, and rates are going up. Capex replacement costs are rising exponentially.”
He feels there is little opportunity for corporates to offset these costs, unless they have demonstrable pricing power, and admits that forecasting in this environment is difficult.
“Assuming any near-term issues will smooth out over time, the second you stretch duration to 5 years from 12 months from an equities perspective, some companies are trading at a 30% discount. This looks extremely attractive. Having said that there is a risk of being early.”
Amy Xie-Patrick, Head of Income Strategies at Pendal Group, believes that while revenue may have fallen, margins have been at all-time highs, so this does provide a bit of a cushion.
However, it is not clear how long it will take for that earnings correction to emerge. She explained that indicators, such as the US ISM Manufacturing New Orders component, point to a 5-6% downgrade in earnings over the next six months, although this has not yet transpired. Since corporates have decent cash buffers and strong balance sheets, she suggested that earnings may prove to be more resilient than usual.
Which regions and sectors present the best opportunities?
Petering believes that Japan is a standout, supported by easy monetary policy, supportive dividend payouts, and cash buffers on balance sheets.
Dillon likes domestic companies globally (i.e. companies with domestic revenues and domestic costs) as this removes global revenue risk. However, as a US dollar investor, currency is the biggest risk. In terms of sectors, he feels that valuations in bond proxies, such as healthcare, are beginning to look interesting.
Xie-Patrick feels China could present a short-term opportunity. Australian investors are currently playing ‘tug-o-war’ with Chinese investments. On the one hand, China’s weighting in global indices is only likely to grow, but on the other hand, there are increasing geo-political risks to consider. However, with valuations at very low levels, and if you believe there is a lot of pent-up demand which could emerge at the end of China’s zero-COVID policy, this could be a short-term play. Longer term, however, there are structural challenges to contend with.
The LGT Crestone view: Valuations are less extreme, but the earnings growth outlook has started to lose momentum. Relatively high commodity prices are a relative positive for Australia, supporting the current overweight. We are underweight Europe and neutral in the US, UK and emerging markets.
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