Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett discusses the latest market developments while Niall Gallagher outlines why he thinks there may be a slowdown rather than a significant recession, as well as where he sees value in European equities.

08 July 2022

David Dowsett – Global Head of Investments

Recession preparation was the theme of the past week. We saw quite dramatic widening in credit spreads and pressure on equities (though notably not to the extent that we have seen previously). The most marked move was the significant fall in government bond yields – with 10-year treasuries falling by approximately 25 basis points over the course of the week. This is a somewhat different pattern to that which we have seen previously when equities and bonds sold off in unison. In core fixed income, at least in the short-term, we are now seeing a response to the weaker growth environment, which suggests that a recession is the near-term threat concerning investors. It is logical that the more central bankers increase their rhetoric about inflation, the more the market fears a hard landing and this is reflected in the way the market is trading overall.

Further themes to emerge from the past week include the threat to energy supplies in Europe, which is a point of concern in the fixed income space and would give further impetus to the risk sell-off. We believe the one week rally we have seen in rates is unlikely to extend any further.

In equities, we are currently seeing valuations in many markets outside of the US at multi-year lows. Over the last 10 years, the percentage of global equity market capitalisation that US equities account for has increased dramatically. It may be that this needs to decrease in order for some of the value that we see in European and emerging market (EM) equities to begin to emerge. We believe there are reasons to see this as a possibility now. It is certainly worth questioning whether the US equity market can continue to outperform in a down market as well as an up market, particularly given the challenges it faces. This could be a catalyst for value to be realised in assets outside of the US, and lead investors to focus on them once again.

Niall Gallagher – European Equities

June was a very volatile month for interest rate expectations. We saw a huge move at the beginning of the month across the curve from the short-end to the long-end and then the market very quickly migrated to fears of a recession as a result of central banks over tightening. Consequently, some of the more economically sensitive stocks sold off. Our view is that we are likely to see a slowdown given the rise in energy costs. However, we do not think the potential rise in rates, although it is a big change to where we were seven months ago, is vastly significant compared to history. Further, given the amount of deleveraging that has occurred across Europe, particularly in Southern Europe, we do not expect rising rates to cause significant strain. However, combined with the rise in energy prices, we do think consumers will experience an element of sticker shock, referring to shock caused by the increased cost of products.

There are a number of reasons we think we may see a slowdown rather than a significant recession: the economic momentum coming into this year for Europe was very good; the credit impulse remains positive; unemployment in the eurozone is at record lows; wages are rising, albeit less than inflation; the consumer balance sheet is very healthy; consumers have a lot of excess savings as people received income replacement during the pandemic but did not go out and spend it but have rather maintained conservative balance sheets. As a result of these factors, we think that in the case of a recession, it will not be very steep. We do not know what will happen next should gas from Russia be cut off and whether parts of German industry will be curtailed because it does not have enough gas or the impact this could have. However, it seems to us that sentiment is very negative relative to the data we are seeing, which does not suggest a harsh downturn.

One of the patterns that has surprised us is that throughout every downturn or bear market in European equities, the equities trade at increasingly lower valuations. They are now trading at lower valuations than those seen in both the global financial crisis and the pandemic. We think some of the stocks may see modest declines in earnings expectations but we do not expect it to be material.

The asset class as a whole is at approximately 11 times earnings, which is very attractive in our view. Although, the market has shifted its thinking to earnings declines, we expect earnings increases in some sectors, particularly banks and energy, as the market begins to impute higher energy costs, higher gas prices and higher interest rates into the earnings of these companies. It may well be the case that the earnings upgrades from these two sectors will create upward momentum in the earnings estimates for the asset class as a whole which will be countered by some of the more economically sensitive areas. Overall, we do not expect a significant decline in earnings going into next year.

The expected material rise in interest rates will be transformative to the profitability of the banking sector in our view. A 200 bps increase in short rates in the eurozone, which is now more than discounted into fixed income markets, would lead to an increase in profitability of approximately 50%. Some are concerned that a recession or a downturn could lead to an increase in bad debt provisions and that this might outweigh the benefits of rate rises which are good for the net interest income of banks. However, we do not think that this will occur for a number of reasons. Firstly, banks have transformed since the global financial crisis. Compared to 2007, the equity to assets ratio, which refers to the amount of capital held by the banks, has increased by a multiple. Banks have also restructured and sold off their non-performing loans, significantly reducing their non-performing loans ratio as well. But more importantly, there has been a significant amount of deleveraging across the consumer and business sectors in Europe. Going back to 2006, Spanish banks would have had loan-to-deposit ratios of 130-140%. This figure now sits at approximately 80%. Therefore we do not think that there is much on banks’ balance sheets that could cause problems. There may be some exposure to Russia or some small areas of consumer finance where we could see some pressure but broadly speaking, banks have been very conservative in their loan lending policies over the last 15 years and have been stress tested multiple times by the European Central Bank. Therefore, our expectation is that we will see a very modest increase in provisions but it will be formulaic to meet accounting standards, mandating an increase in provisions with GDP forecast declines. The sector is trading on the lowest valuations it has ever traded on, with stocks approximately five times earnings. We think we will eventually see the market begin to recognise these low valuations, an increase in earnings and the fact that we may not experience a decline in credit quality. We believe that without the recession concerns, we would probably see these banking shares being valued at 40 or 50% higher than they are currently.

Similarly, energy is set to benefit. The thesis here is much simpler: we expect oil and gas prices to remain high. They are generating huge amounts of cash as a consequence and we expect those higher oil and gas prices to be maintained over the next few years.

Elsewhere, we have not seen a big construction cycle in the developed world over the past 12 or 13 years since the global financial crisis. As a result, some of the building/construction materials stocks are not over earning but are trading at the most attractive valuations we have ever seen; in order to justify the current prices, there would need to be a 30-40% fall in construction volumes which we do not think is likely.

The market has generally not differentiated between quality and growth stocks. The quality basket is comprised of those stocks which had top line growth rates of 6-8% and the valuations of these businesses rose enormously – the PE ratios in some cases doubled between 2015 and 2021 but there was no change in the underlying growth rate. What we perceive happened here was that those equities absorbed the ultra-low bond yields into lower cost of capital and that pushed up the valuations. The growth stocks, on the other hand, saw explosive levels of growth and in many cases, the growth rates increased over the course of that time period because of some of the structural trends, such as semiconductor capex equipment companies or payment companies where there was a pickup and acceleration in the rate of growth of the businesses. The distinction we would make is between those companies where the growth is very high and was accelerating versus those where there was no change in growth. The valuations of both went up and we believe in one case it was justified and in the other case it was not. But the market has not made a distinction this year – both have sold off. However, in time the stocks that we think have very good growth prospects which have sold off materially are now very attractive relative to their growth prospects, while many of the quality companies have come back down somewhat but really are not particularly attractive given the prospects of the company, in our view.