The month the pandemic equity rally died
Head of Equity Strategy
Summary: Global equities finally experienced a drawdown of more than 5% yesterday as investors are adjusting their outlook for inflation and growth amid rapidly rising commodity prices and most importantly energy prices. Everywhere we look input costs for companies are going up and when the Q3 earnings season starts in two week investors will be surprised how bad the situation has become and the number of profit warnings. We recommend investors to increase exposure to mining, energy, cyber security, logistics, semiconductors, and also market makers for downside protection.
Yesterday, the MSCI World hit a drawdown of more than 5% based on closing prices ending the 237 trading days long rally in equities since the world came out of the abyss and reached new highs. The combination of a housing market crisis in China and an unfolding global energy crisis was the excuse investors were looking for to reduce market exposure.
The energy crunch is becoming an acute situation for the world with a German coal power plant running out of coal and India only having 3 days of coal inventories for its 135 coal power plants. The surging energy prices are pushing up prices on everything from solar panels to vegetables grown in greenhouses. Bond investors are also finally waking up to the reality pushing interest rates higher and BlackRock’s Vice Chairman Hildebrand predicted today that inflation rates will remain at higher levels than what we have experienced in the previous two decades. Everywhere we look input costs such as wages, metals, energy, and interest rates (financing on debt) are going up which will impact profit margins sitting at an all-time high.
Investors will be surprised in the Q3 earnings season how painful the current environment is for businesses. Bed, Bath and Beyond lowered their outlook yesterday, and Nike and FedEx both warned of margin pressures last week. This will become the big theme when Q3 earnings releases start coming out in two weeks’ time.
Short-term risk will be dictated by the marginal cost of energy and if the energy crunch gets worse it will force equities lower. We could see a correction of 15% in equities. Key to watch are interest rates, energy prices, the USD, and curvature of the VIX futures curve. The fact that we are 80% higher in global equities since the bottom will make many investors quick to realize some of their gains as the return is beyond what you would expect over many years.
When we look at our equity theme baskets the pain is becoming more obvious with now also the MSCI Emerging Markets Index dipping into negative for the year. Themes around India, logistics, financial trading, semiconductors, and commodity sector are still doing great and we recommend investors to get exposure to these theme balancing their technology and growth stocks in the portfolio. While we expect a bigger correction we do not think investors should panic. With very low interest rates and a rising inflation outlook there are no real alternatives to equities unless you think you can time the market and go into cash at the right time. Our approach is that investors should increase exposure to mining and energy, but still keep profitable technology companies with high return on equity. Investors could also considering adding market makers to their portfolio hedging the downside risks.