August 2022
Key points for your clients:
- Inflation fell and markets responded, however it’s important to keep in mind that a Fed target of 2% suggests the doves may be too early.
- Antipodes is positioning for a fundamentally different regime for markets, with central banks tightening as economic activity slows.
- Antipodes thinks a contrarian approach to investing is the right way to navigate today’s markets – Europe is a good example of a consensus sell that could offer contrarian opportunities.
- Stagflation remains Antipodes’ base case, but the outcomes around economic activity and inflation are wide, and the team expects greater economic volatility.
Unchartered territory
The last 30 years have been characterised by falling interest rates and inflation, low volatility in GDP growth, and where the Fed stepped in at the first sign of asset price volatility.
But we are now in a fundamentally different regime for markets.
As a consequence of multi-decade high developed world inflation, we have Western central banks tightening as economic activity slows.
In this next slowdown we’re also going to see policy makers lean on fiscal spending – or fiscal activism – as the primary tool to support economies as opposed to the passive outsourcing of economic policy to central banks via Quantitative Easing and asset price stimulus that has defined the last two decades.
Shorter-term, governments are grappling with a cost-of-living crisis and lower income protection which will put further pressure on fiscal positions.
Longer-term any investment stimulus will focus on supply chain strengthening, decarbonisation and infrastructure. These are all areas where we are finding good long-term opportunities for global equity investors.
Looking forward, our base case remains stagflation and that a slowdown in economic activity or even a mild recession in the West can be offset by a stimulus-driven recovery in the East to avoid a global hard landing. But the range of outcomes around economic activity and inflation are wide, and we expect a far greater amplitude to the economic cycle going forward.
Don’t be blinded by July’s inflation print
Combined with the Fed’s recent comments around reaching the neutral interest rate, last week’s inflation reading of 8.5% temporarily sent relief through the market, and especially for some of the riskier names. However, it’s still the equal second highest inflation reading in over 40 years.
CPI remains well in excess of the Fed’s c. 2% target, and rhetoric around interest rate policy has remained steadfastly hawkish. Persistent pressure from wages, rent, energy and food prices can prevent the Fed from sharply reversing interest rate policy and QT.
Economic uncertainty and higher discounts rates will see the market more focused on valuations than over the last decade.
That doesn’t mean every low multiple company is going to be a good investment. Investors need to be selective in a backdrop of stagflation. Growth stocks will be vulnerable to higher discount rates while value stocks will be vulnerable to weaker economic activity – so called Growth and Value styles will become more correlated.
Likewise, when it comes to bonds and equities, we expect higher correlation to continue.
Equity markets will become more stock specific which favours active management, and tight credit conditions will see the market revert to favouring resilient businesses with strong balance sheets.
… And think long term when it comes to Europe
A contrarian mindset can help navigate a more volatile economic environment.
Europe, a consensus sell, is great example of a contrarian play.
The ECB is in an even more delicate position than the Fed. The risk around economic activity is higher given the backdrop of war, and food and energy prices are particularly elevated. More pain is likely as Europe strives to decouple itself from Russian gas.
Europe’s key energy pinch point is the next three or so months as Europe needs to build sufficient gas stores to get through winter.
There are many moving parts.
Will Russia continue to deliver some gas (c. 30% of the pre-war volume)?
Can Europe successfully secure additional LNG cargos to plug the gap?
And, of course, the weather.
It won’t be easy for Europe to replace the lost Russian gas – it is possible, but it will be costly. The additional cost to the European economy from higher gas/energy prices and more LNG could equate to 2 – 3% of GDP.
The tail risk remains that Russia stops pumping gas completely. The fallout will be felt most acutely in Italy and countries to the south-east of Germany. These countries would have to come up with gas rationing plans over winter and solidarity between the neighbours will be key. In the short-term, Putin has a powerful card to play if he feels increasingly cornered by the West and this needs to be monitored closely.
The best opportunities in global equites
Despite the extreme moves since the beginning of the year, low multiple, or so-called Value stocks, are still cheap relative to higher multiple, or so-called Growth stocks. We’re finding opportunities across regions and sectors which means we don’t have to wed to traditional “cyclical/value” sectors.
Also, given the slowing economic outlook, we have been reducing the cyclical tilt in the portfolio since late last year.
We’re finding good long-term opportunities around emerging investment cycles, with around 30% long exposure to energy transition (e.g. EQT, Siemens, RWE) and connectivity and compute (e.g. Frontier Communications, Seagate).
We remain underweight the US relative to the benchmark as US equities are still around twice as expensive as the rest of the world. But the meaningful correction in US tech and domestically exposed equities is providing opportunities to deploy capital at the margin e.g. around Enterprise Resource Planning (Oracle) and financials. With regards to ERP, only 20% of back-office workloads have moved to the cloud compared to 60% of front office workloads and Oracle (along with German company, and portfolio holding, SAP) will be key beneficiaries of this ongoing transition. Exposure to ERP can be more resilient even in a tougher economic environment as moving to the cloud is invariably a cost saving and/or productivity decision.
Exposure to Europe may feel uncomfortable today, but at 12x forward earnings (versus an average of 16x over the last five years) the market is already pricing in a tough scenario around energy and recession. If Europe can muddle through, European equities look cheap. The bulk of our exposure is focused on multinationals – leading franchises that generate revenue and profits globally and aren’t dependent on just the European economy e.g. Siemens, SAP, Sanofi.
With regards to China, the timing around a full reopening is unclear but the situation is moving in the right direction evidenced via higher subway, airline and intracity movements, and cargo freight. The market isn’t pricing in reopening, policy change or the potential for more stimulus, and the Communist Party is incentivised to restore economic stability. China has fiscal and monetary firepower and doesn’t have an inflation problem acting as a handbrake to stimulus. Our exposure focuses on domestic businesses that will benefit from a cyclical rebound in economic activity and structural consumption trends e.g. Trip.com, JD.com and Yum China.
Above all, we are conscious of tail risks.
We cannot ignore that relations between the US and China have recently soured further, and this impacts the risk/return profile of investing in China. Consequently, we’ve diversified some of our emerging market exposure to outside China where we see similarly attractive valuations with less geopolitical risk.
Outside of rising geopolitical tensions, the key tail risk is central bank policy error. Whether that’s the Fed or the ECB tightening too aggressively into slowing economies, or China waiting too long to stimulate.
Interest rates are a blunt tool; hiking rates will intensify any economic slowdown without addressing inflationary pressures that are driven by supply side issues i.e. tight labour markets, the underbuild in the US housing market since the 2008 financial crisis, and the fallout from the war in Ukraine.