Chief Investment Strategist
Summary: The honey moon in equities since the lows in 2020 is over. Equities have gone from a regime of extreme stimulus and very loose financial conditions with profits and equity valuations exploding higher. The current regime is a minefield of downside risks with inflation hitting profit growth, geopolitical risks which could worsen the ongoing energy crisis, higher interest rates compressing equity valuations, and growing questions marks over China's economic activity this year. It all points to a defensive stance on equities and the coming months could be rough.
Equities are navigating a minefield of risks
It all started on a positive note early Monday morning following a nervous ending to last week amid escalating rhetoric in the Russia-Ukraine conflict as a potential summit between Biden and Putin had in principle been agreed to according to the White House. However, Kremlin was quickly out saying that there were no concrete plans, and now fast forward Nasdaq 100 equity futures are flirting with levels seen during the lows in January. The 13,831 level is a key level to watch on the downside and a close below today could mark the beginnings of a new leg down in US technology stocks.
Equities are generally negatively impacted from higher inflation eating into profit margins, higher interest rates impacting valuations through a higher discount rate on future cash flows, a potential war in Ukraine which could jolt energy and commodity markets around the world, and fiscal stimulus subsiding substantially this year. Following 20 months of very strong equity returns the market is beginning to reflect very different forces in our economy. Nasdaq 100 futures are down 17.2% from the highest in November and that’s even before a significant tightening of financial conditions in the US relative to the economic backdrop.
Equities were too quick this morning to buy the rumour on a summit between Biden and Putin, but the reaction was much more muted in commodities and especially the oil market. The physical commodity markets have much better information gathering on the ground and our view is that commodity markets will by far be the best signal on the geopolitical risks out of Ukraine and thus equity investors should use commodity markets as the go-to indicator to filter out the noise.
Another way to look at equity market risk is by observing spread between US inflation and the US earnings yield (inverse P/E ratio). The current P/E ratio has reached its biggest negative spread to the historical relationship between inflation and equity valuation. There are several ways to read this chart. One is that investors are believing inflation will quickly come down to 2-3% and stay there thus quickly pushing equity valuations back into the “safety zone”. Second, equity valuations are significantly out of line with the underlying inflation and as soon as the market gets its eureka moment that inflation is more structural then equities could easily decline another 15% without it being outrageous. The middle ground interpretation is that we will move in a 45-degree angle from the orange dot towards the regression line, which would reflect a combination of lower realized inflation but higher long-term inflation expectations and thus a repricing of US equities towards lower P/E ratios.
Chinese technology stocks are difficult this year
Chinese technology stocks had an ugly Friday session as new policy on Friday is aimed to curb fees of delivery companies hitting stocks of Meituan. The leading Chinese technology index, Hang Seng Tech, was trading lower again today down 49.5% from the weekly peak back in February 2021. Chinese equities have generally been hit by a slowdown in economic activity, a brewing housing crisis related to the country’s big real estate developers, and an energy crisis impacting industrial profits. But technology companies have in addition been hit by technology regulation aimed to tame the market power and anticompetitive behaviour of large technology companies. This has lead to a severe growth slowdown for Chinese technology companies and the worry is that regulation of the industry is not over yet. Our view is that Chinese technology stocks might look cheap but that it is likely a trap for investors as a lot of negative sentiment could hit Chinese technology stocks until we get on the other side of the CCP Party Congress in October.
Earnings this week and the profit margin squeeze
This week will see another roughly 200 earnings releases out the 2,500 earnings releases we track during the earnings season. The US earnings season is mostly done leaving the stage for European and Chinese equities, and this week will see several important earnings releases across many different industries. We will be closely watching earnings from HSBC, Home Depot, MercadoLibre, Rio Tinto, Danone, Booking, eBay, Saint-Gobain, Alibaba, Block, Moderna, Coinbase, BASF, Amadeus IT, and Li Auto.
Home Depot is a key earnings release related to the US housing market which is currently on fire despite mortgage rates have increased 100 basis points this year. MercadoLibre is South America’s largest e-commerce company and is part of our e-commerce theme basket which has been under pressure this year and thus there is a lot of attention on e-commerce companies. Rio Tinto has a large footprint in the global mining industry and can give us new insights into the supply and demand imbalances. Danone is a large food company and thus can provide colour in inflationary pressures in consumer foods. Saint-Gobain is typically not a company we watch but with galloping prices on construction materials this earnings release will be more interest to watch than normal. This week’s most important earnings release will come from Alibaba on Thursday which will set the tone for Chinese technology stocks in the weeks to come. On Thursday several US technology companies such as Block, VMware, Autodesk, Dell Technologies and Coinbase will report earnings.
The most important take away from the Q4 earnings season is the contracting net profit margin which is declining for the second straight quarter in the MSCI World Index to 10.8% in Q4, which is the fourth highest reading since early 2003. We expect the net profit margin to continue to mean-revert towards the long-term mean at 7.5% suggesting a whopping 3.3%-points headwinds for global companies adding to the downward pressures in equities.
The most important earnings releases next week:
Monday: Williams Cos
Tuesday: Hang Seng Bank, HSBC, ASM International, Norsk Hydro, Home Depot, Medtronic, MercadoLibre, Palo Alto Networks, Agilent Technologies, Mosaic
Wednesday: Rio Tinto, Danone, Munich Reinsurance, Barclays, JDE Peet’s, Iberdrola, Oversea-Chinese Banking, Lowe’s, Booking, TJX, Stellantis, eBay
Thursday: Anheuser-Busch InBev, Royal Bank of Canada, Canadian Imperial Bank of Commerce, AXA, Safran, Saint-Gobain, Deutsche Telekom, Sun Hung Kai Properties, Hong Kong Exchanges & Clearing, Anglo American, Lloyds Banking Group, BAE Systems, Alibaba Group, Intuit, NetEase, EOG Resources, Block (formerly Square), Moderna, Newmont, Keurig, VMware, Autodesk, Dell Technologies, Monster Beverage, Coinbase, Zscaler
Friday: BASF, Amadeus IT, Holcim, Swiss Re, Sempra Energy, Li Auto
Saturday: Berkshire Hathaway Quarterly Outlook
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