Second Half Equity Strategy

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Various institutions provide their outlooks for inflation, monetary policy and commodity prices and offer portfolio recommendations to counter current risks.

-Recession or no recession?
-How to protect against stagflation
-Local equity preferences
-A wider view of global risks

By Greg Peel

JPMorgan’s global research team rather understatedly notes the first half of 2022 has been “difficult for investors”. While a fall to date for the S&P500 of -20% is seen as “modest” compared with -35% in the 2020 covid crash and -50% in the GFC, the reality is a “typical cross-asset portfolio”, implying a mix of stocks, bonds and cash, has declined more than any other downturn since the GFC given a simultaneous decline in stock and bond prices.

The major driver has been a sudden shift from the Fed to aggressive monetary tightening in order to address inflation which is ironically, as JPMorgan notes, out of the Fed’s control, given it is driven by energy and food inflation, covid-disrupted supply chains and the war.

The most recent step-up in Fed aggression has led to markets fearing such action will lead to economic recession. This leaves economists and strategists in a difficult position, JPMorgan suggests, of guessing whether central banks will make another mistake (alluding to the Fed’s failure to respond to inflation and post-covid US economic recovery until the midnight hour) and simply compound the damage produced by years of underinvestment in energy, the impact of covid lockdowns and the war.            

But JPMorgan’s economists do not see a recession materialising in 2022. The probability of recession has certainly increased meaningfully, but the economists see global growth accelerating from 1.3% in the first half of 2022 to 3.1% in the second.

This is linked to a forecast decline in global inflation from a 9.4% annualised rate in the first half to 4.2% in the second, which would allow central banks to pivot and avoid producing a downturn.

This forecast is connected to two critical assumptions.

Firstly, that China’s growth will accelerate to 7.5% (annual) in the second half from as good as zero in the first.

As the first half reflected the impact of widespread lockdowns, JPMorgan’s forecast must thus assume no further lockdowns, despite no change to China’s zero-covid policy.

The second is an assumption the second half will bring progress towards a solution in Ukraine or at least a lasting ceasefire, easing geopolitical fears.

We note that the Soviet war in Afghanistan lasted ten years before the Russians withdrew. Yeltsin’s war on Chechnya last two years, before Putin came back three years later for another eight years, and then withdrew.

The war in Ukraine has been underway for a bit over four months.

On JPMorgan’s assumptions, the economists still believe in the commodity supercycle, and view commodity-related assets, sectors and countries as both a valuable source of returns and a hedge against inflation.

JPMorgan is among many financial institutions who released their second half market strategy reports in June, which reflect a lot of time and effort to produce, so much has transpired in the meantime. JPMorgan is but one house which, drawing upon the history of high-inflation periods, recommend commodities as an inflation hedge.

But are commodities really a hedge against inflation? Commodity prices are inflation – energy, food, fertiliser, metals/minerals… Since the end of June, the falls in commodity prices brought about by recession fears and an assumption of “demand destruction” have only accelerated, and most notably oil prices fell -20% to below US$100/bbl, before recovering slightly.

For JPMorgan’s forecast of 4.2% second half global inflation to prove accurate, it will only be largely because of falling commodity prices, and if inflation numbers begin to turn down meaningfully from this month, central banks may yet ease off the accelerator and recession fears will abate.

The near-term end-point for inflation will still be beholden to the longevity of the war, Chinese lockdowns (or not), lack of spare capacity in oil production and the “stickiness” of wage inflation.

JPMorgan’s view is there will be no recession, but markets are pricing in recession. On that basis risky assets are too cheap. US small cap stocks currently trade near the lowest valuations ever, with many market segments down -60-80%.

“Positioning and sentiment of investors is at multi-decade lows. So it is not that we think that the world and economies are in great shape, but just that an average investor expects an economic disaster, and if that does not materialize risky asset classes could recover most of their losses from the first half. Our bullish and out-of-consensus view is hence a forecast of a lost year, ie a recovery of [first half] losses in risky assets.”

S&P500

Most US investment houses are forecasting the S&P500 to close 2022 above where it is now (3900), albeit having lowered their targets from prior levels.

Yet there remains a prevailing view that an ultimate bottom is not yet been seen, and the 3400-3500 range is the popular target.

The assumption is that despite the bear market of the first half, the impact of the Fed’s aggressive rate hikes and quantitative tightening are yet to be fully felt. The net S&P500 price/earnings multiple has fallen from lofty heights at the beginning of 2022 to around 15x now, but 15x is the historical average. Hence sentiment has only fallen from overblown to average, which does not reflect the below-average sentiment one would expect if a recession is in the offing.

But the question of whether the US is headed for (or already in) recession splits the market. As does the question of whether a -20% pullback for the S&P500 reflects a recession already being priced in. Another prevailing view is that earnings forecasts for the June quarter are too high, and not reflective of margin headwinds, which is why the index must yet go lower before a true bottom is in.

That question will begin to be answered this week, when the first major earnings results are released.

Citi’s strategists are not of the view earnings forecasts are too high.

Citi has set a year-end target for the S&P500 of 4200, down from a prior 4700, implying low double-digit upside in the second half.  Earnings resilience is a key differentiator to the strategists’ view.

Fed hawkishness and the rising real rate impact on valuations has been a defining feature of the first half drawdown, as stubborn inflation has persisted. But Citi believes this is mostly priced into the current index level and PE multiple. Better than feared earnings and signs of peaking rates, combined with bearish investor positioning, support a positive second half risk/reward set up, the strategists believe.

Citi’s year-end S&P net earnings forecast is at the higher end of consensus and the strategists apply an 18-19x PE multiple to that number to reach 4200. However:

“Recession probability, timing, depth and duration all need to be considered. Lingering inflation and risk of stagflation have not been resolved. Earnings risk is a bigger issue for next year, in our view.”

Global

Speaking globally, Macquarie is among those believing analyst earnings revisions are lagging equity prices, but notes this is “common” in volatile markets. While PE value spreads have contracted, the strategists note they are still above long-term averages (globally).

This suggests further downside risk to company fundamentals.

Central banks are poised to do “whatever it takes” to counter “hot” inflation, and weak fixed income returns, struggling equities and strength in commodities have “followed the playbook” set by previous periods of high inflation.

Looking back as far as the 1960s, Macquarie finds stronger equity returns from Value compared to Growth and on a sector basis, strong returns for energy and defensive sectors of healthcare and consumer staples. Sector returns to date in 2022 are also largely following the script, the strategists note, for high inflation regimes.

Over a longer term horizon, Growth at a Reasonable Price (GARP) and Defensive Value remain Macquarie’s preferred exposures given the challenging outlook.

Local

Screening for both GARP and defensive value, Macquarie singles out eight Australian stocks that stand out:

QBE Insurance ((QBE)), Suncorp Group ((SUN)), Coronado Resources ((CRN)), Mineral Resources ((MIN)), Woodside Energy ((WDS)), Santos ((STO)), Viva Energy ((VEA)) and Westpac ((WBC)).

Macquarie has an Outperform rating on all of the above bar Woodside and Westpac, for which it has Neutral ratings.

Drawing upon academic research from 2021, Macquarie notes that in general, inflation is bad news for fixed income assets and generally a tougher time for equity strategies. Commodities, in aggregate, had a “perfect track record” of generating positive real returns during the eight regimes identified as inflation periods (in contrast to normal periods where commodities generate single low digit returns). Momentum and quality work, with small negative real return to value, whilst size fares somewhat worse.

Although we note three of the eights stocks selected above are ASX top 20 members.

Recession is not a foregone conclusion, suggests Morgans, but monetary tightening is upon us. Investors are thus advised to keep duration short on fixed income and equity.

For fixed income, this implies short maturities rather than long. For equities, it implies profitable businesses generating solid cash flows today, rather than growth companies valued off longer term earnings potential.

Morgans believes the rises in global government bond yields and falls in equity prices have further to run. Government bond yields have typically peaked shortly before the end of central bank tightening cycles and the strategists expect most major central banks to continue hiking rates over the next 12 months.

The increase in government bond yields, as well as the threat of slowing global economic growth, will keep risk assets such as equities under pressure. This environment may see some continued widening in credit spreads. Morgans suspects markets will start to turn a corner later this year as tightening cycles near terminal levels.

Tactically the strategists prefer a portfolio closer to home (Australia) with economic conditions holding up and inflation concerns less acute than global peers. In Morgans’ view, strong employment conditions will provide an offset against a backdrop of falling house prices and weaker consumption.

Yet Morgans removes its Overweight stance on Australian equities in the September quarter acknowledging the near-term risks.

A resilient earnings outlook assisted by higher commodity prices, in the strategists’ view, will see Australia outperform global peers, but Australia is not immune to the inflationary backdrop. Morgans recommends an Overweight position in cash given the risk of heightened volatility over the next few months.

Retaining a preference for inflation protection, with escalating prices unlikely to unwind given the supply-chain challenges and higher energy costs, Morgans also suggests non-traditional return streams (alternative assets) including unlisted real assets and commodities, have the potential to add value and diversification.

Exchange-traded funds provide for such investment.

Globally, Morgans is Underweight equities due to a risk of central bank over-tightening and a deteriorating outlook in Europe and China. Despite sharp falls, the strategists believe US equities remain overvalued.

Morgans is Neutral on Australia equities, believing above-average earnings growth will be harder to come by. The strategists prefer a targeted portfolio approach favouring the reflation trade – financials and energy – and quality cyclicals with strong market positions that can absorb rising costs.

The Wider Picture

In the first half of 2022, the war in Ukraine hindered the recovery of the global economy in the post-pandemic stage, ICBC notes. In the second half, ICBC believes the global economy is experiencing a “triple change”.

The first change is that global stagflation is materialising in the short term, the second is money supply is shifting from external to internal in the short-medium term (central banks moving to quantitative tightening from quantitative easing), hence a global economic recession is expected to be “more notable”, and third is that in the medium to long term, anti-globalisation and geopolitical risk is intensifying global trade protectionism (such as energy and food) which may worsen geopolitical conflicts.

ICBC expects the Fed and the ECB to further prioritise inflation control in the second half, accelerating monetary tightening in tandem. Facing the deep correction of global assets, on the one hand emerging markets will raise interest rates at the same time to curb inflation and prevent capital outflow, and on the other hand some commodity-exporting countries may turn to champion global energy and food protectionism and use their commodity pricing advantage to hedge against the potential capital outflow and currency devaluation.

ICBC thus offers a dire warning. From a global perspective, the increasing imbalance between global food supply and demand is pulling more countries into food crises. Should more and more developing countries and emerging markets fall into the quagmire of serious food shortage, it cannot be ruled out that geographical famine may trigger a new round of military conflict.

If this is the case, the global economy may be hit even harder.

For China, four positive factors will support the full recovery of the economy over the second half of the year, ICBC believes, namely an infrastructure rebound in sight, a consumption rebound in sight, supply chain resilience to smooth the pace of export decline, and a weakening drag from real estate industry. ICBC forecasts 5% GDP growth in 2022.

“The capital market can be quite certain about China’s economic recovery in the second half of the year. At the same time, China’s inflation pressure is significantly lower than that of other major economies, and it has relatively ample policy wriggle room.”

Again we see no mention of further lockdown risk.

Note that ICBC stands for Industrial & Commercial Bank of China, which is state-owned.

A New Paradigm?

If there is one thing Denmark’s Saxo Bank disputes, it is that central banks will be able to return inflation to a targeted 2-3% level.

In its outlook for the September quarter, and for the balance of the year, Saxo argues that the market fails to understand that we have shifted into a new paradigm for the economy, inflation and the incoming policy response. Inflation will prove a “runaway train” that central banks can only chase from behind until the inflationary dynamics result in a crash into a hard recession.

But that eventual recession won’t mean that we are set for mean reversion back to disinflation and calm conditions, Saxo warns. That’s because inflation is here to stay, driven by de-globalisation and supply-side shortcomings from decades of underinvestment in the physical world, as policy was over-geared toward pumping up leverage and ever greater financialisation of the economy.

In equities, Saxo argues the market has undergone one of its largest sentiment shifts in the past 100 years in just six months. This was after it dawned on the market that the famed “Fed put” has been thrown out the window as the Fed finally realised it must focus single-mindedly on tightening conditions until inflation is reined in.

The “Fed put” refers to market confidence that if US equity markets begin to tumble on tighter monetary conditions, the Fed will reverse course to ensure stability.

Under Saxo’s macro theme that the supply side of the economy has suffered underinvestment, the new landscape for equities should favour tangible assets such as logistics, commodities, renewable energy, infrastructure and defence.

The energy sector is the only positive sector in US equities this year and, with its rising importance in equity indices, Saxo foresees a potential crisis in environmental, social and governance (ESG) funds due to their significant underweight in oil and gas stocks.

Given its focus on inflationary risks due to the physical world being unable to keep up, Saxo admits it is “interesting” that its commodities outlook notes that commodities are fretting risks to the downside in the short to medium term as the market predicts an incoming recession due to the policy tightening and a demand adjustment after severe price rises over the last year.

But for the longer term, decades of underinvestment in capacity and the need for the metal-intensive push for a more carbon-neutral future leave Saxo convinced that commodities remain in a rising super-cycle.

By implication, good for Australia.

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