| After a very tough first half of 2022, global markets are 20%-30% cheaper than at the beginning of the year, depending on which indices investors reference. Most shares are below their pre-pandemic levels (January 2020) and many buying opportunities are emerging. An uncertain global market outlook has shaken investor confidence and we expect high volatility to be sustained and it is unclear when the market will bottom. It always is. However, we have now reached price levels at which we would be happy to be a buyer of shares on a further dip on a 12-month view. It is quite conceivable that markets will be c. 15% higher in 12 months as global interest rates increases have peaked and the market looks forward to the next phase of the cycle. The risk is that it takes a little longer than 12 months, which we believe is a risk worth taking. As we wait, the companies we own will become fundamentally more valuable as they generate cash, invest in their businesses, and buy back shares. Very simply, a drop of this magnitude is generally followed by an above-average next 6-12 months as when fearful, the market typically prices in an outcome worse than what materialises. Investing now feels very uncomfortable, but this is when good businesses can be purchased at attractive values. Most importantly, share-specific opportunities surface which have not been available for the past year or two. This scenario is good for some companies and bad for others. The high inflation environment is great for quality companies with pricing power, which is the focus of our investment philosophy. Many “value” or defensive/lower-quality companies have held up well and could be a drag on index returns going forward. This is a time for doing less rather than more, as markets find their levels, but we are continually reassessing the thesis for all our investments to assure us of their durability. A very rapid change in the economic outlook has occurred over the past six months. Only six months ago the market was not expecting a rise in US interest rates in the first half of 2022. Fast forward six months and we are in the midst of an aggressive rise in interest rates, with the market already pricing in interest rate declines as soon as 2023! Economists and strategists are, in aggregate, particularly bad at forecasting the short-term future. Market commentary and expectations are broadly negative with consistent and consensus themes; sustained high energy prices, as well as high and sticky inflation, leading to sustained interest rate increases which drive down economic growth and result in earnings downgrades. The common message is that this will drive the last leg of the bear market and see a further leg down. We highlight the consensus expectation that analysts will downgrade earnings forecasts and hence they will come as no surprise. It is surprises that move markets, not the actual events themselves. We would be more bullish if valuations were lower, as they have come from elevated levels at the start of the year. Valuations 5%-10% lower would fully incorporate potential earnings downgrades and would approach “banging-the-table” levels. The risk to our thesis is that earnings downgrades are bigger than expected. The market is now priced for a moderate decline in economic activity and the risk is that the US Fed overshoots in the short term. However, if the US economy gets throttled too quickly, we could well see the Fed “chicken out” and hold back on further action. US inflation numbers will be watched closely. We expect that US inflation has peaked and will decline back to normal levels over the next 18 months, however, inflation is a lagging indicator and will remain frustratingly high for the next few months. The graph below shows the MSCI World Index forward P/E multiple, which is now at a more digestible 15x. With earnings growth of above 10% in the past six months and indices declining, the market is over 25% cheaper than it was six months ago, and certain sectors are 20%-50% cheaper. We have shifted from growth companies all being given the benefit of the doubt to an environment where a premium is placed on certainty and the premium for growth is the lowest in the past five years. |
| Figure 1: MSCI World fwd P/E Source: Bloomberg, Anchor. |
| Some comfort also comes from the fact that US households and corporates started 2022 with strong balance sheets and relatively low debt levels. World GDP growth is projected to be reasonable this year, but Bloomberg consensus data have projected 3.6% world GDP growth this year – downgraded from the earlier 4.4% consensus growth forecasts for 2022. There is a risk this could be lower. DM interest rates are also coming from close to zero and we do not expect them to be increased to unpalatable levels. The absolute levels of projected interest rates will still be average to low by historic levels and still at levels where a reasonable ROE can be earned on new capital investments. |
| Figure 2: Global GDP growth Source: IMF, Anchor. |
| We also favour small exposure to EMs, particularly China, whose listed shares have risen sharply in recent months, as we projected in our The Navigator: Strategy and Asset Allocation, 2Q22 report, dated 12 April 2022. In contrast to the US, China is stimulating its economy to drive growth and the government has, for the first time in 12 months, made market-friendly statements. This has seen a sharp bounce in Chinese shares off their extreme lows, although they still trade at record-low valuations relative to their US counterparts. Geopolitical uncertainties are the highest they have been in decades, but the upside optionality and risk/reward equation favour some portfolio exposure. Figure 3 shows the relative value of EMs (forward 11x P/E), where we expect growth to be the strongest in year-two. |
| Figure 3: Various global indices EPS growth and fwd P/Es Source: Iress, Anchor |
| The simplest and most compelling argument for equity ownership is the graph below, which illustrates the 9% US dollar-denominated annual earnings growth rate for the past 20 years. Market returns follow earnings growth (plus dividends) over time, and any investor should be delighted with an annualised return of this magnitude. As indicated above, Bloomberg consensus data could well be downgraded, but we would argue that, while analysts might have to catch up, most fund managers already have this baked into their expectations. Lower-than-projected earnings growth in 2022 and 2023 would probably see a bigger earnings growth rebound in 2024. |
| Figure 4: S&P 500 EPS growth (annualised) Source: Bloomberg, Anchor. |
| It feels risky talking about positive double-digit 12-month market returns in the face of economic headwinds, and it is. Things could turn out worse than expected in the short term, and the market awaits the US 2Q22 earnings season with trepidation. Subdued earnings and prospects statements could drive specific shares (and maybe the market) even lower, and, for new money, we would deploy capital in tranches. However, our inherent belief is that trying to time the market in the short term is fairly random, and we focus on the long-term values of quality businesses. Many good companies are now trading at below their long-term fair values, and we would be even more compelled to buy these shares in the event of further short-term downside. One last point is that US 10-year bond yields trade at around 3%, which is probably a fair level. At a forward 16x P/E, US companies are, on average, trading at a 6.25% yield on earnings (1/16). The differential is 3.25%, a fair reward for taking equity risk over bonds. When the equity outlook is poor this differential has historically got much higher but trying to time the absolute bottom often results in missed opportunities. From a long-term perspective, we are happy to buy around these levels. If you have any further concerns and queries, we are available to take your call and assist in any way we can. This note is courtesy of Peter Armitage, CEO/CIO of Anchor Capital. |
