Head of Equity Strategy
Summary: If the worsening inflation outlook finally pulls the US 10-year yield to 2% then value stocks are likely in for a period of outperformance against growth stocks. GE's decision to break up its conglomerate of businesses is right one despite investors not seeming to put a big value on it. The times have changed and investors today want pure exposure to industries and technologies.
Value stocks could enter a new tactical period of outperformance
The higher than expected US inflation in October hitting 6.2% y/y on the headline CPI was a bit of shock, but not to our team as we have been leaning away from the transition camp on inflation this year. Underinvestment in the physical world (energy and mining), supply constraints, huge demand in the developed world, rising rent prices, and wage pressures will continue to carry inflation at a higher level through 2022. This will put upward pressure on interest rates in the long end of the US yield curve. Investors in US Treasuries would just barely have preserved their capital in real terms since 2015 (see chart), but with the current nominal yields and outlook for inflation capital in real terms is going to be shredded at a rapid pace in 2022. The only meaningful response to preserve capital in real terms is for nominal yields to go higher.
The last time we had nominal yields on the rise was from early November 2020 to April 2021, it caused a rally in global value stocks outperforming global growth stocks by 18% before giving up most of the gains as growth stocks resumed their rally. If we are right on inflation and the response in yields, then energy, financials, and mining companies will drive the outperformance in value stocks. From a tactical point of view it is worth playing. Long-term our view is still that investors should have exposure to the commodity sector, cyber security, semiconductors, India, logistics, and mega caps.
Could the anti-conglomerate thinking come to technology?
The move by General Electric to break up the conglomerate into three separate companies follows a successful divestment strategy of Siemens, although we would argue that Siemens could be simplified even more. The two most iconic industrial conglomerates have finally caught up by the times and especially the evolution of investment theory on portfolio management. Nowadays, investors want pure plays on industries and technologies, just look at how Tesla is being rewarded by investors for being the only meaningful pure play on the future of electric vehicles. In the short-term it does not look like investors are impressed about the GE plan in which the debt split is one of the key outstanding issues. However, longer term it is the right decision and more companies should look hard at their businesses and consider whether there are any synergies between. If not, simplify the business.
The bigger question is whether the push to divest businesses that have no obvious synergies will come to technology companies as well. They have long been shielded from these pressures as they have most concentrated on the old industrials that embraced the conglomerate philosophy in the 1960s. Amazon is an interesting case where the synergy between the cloud business (AWS) and the e-commerce business is quite low. In 2020, the AWS business generated $13.5bn in operating income compared to $9.4bn for the combined e-commerce business. The cloud business comes with much higher operating margin and less CAPEX needed to drive incremental revenue, so investor demand would be extremely high for a pure play on the world’s largest cloud business. Maybe GE will be an inspiration for Amazon?
2024: The wasted year
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
