It’s all about time

After a disastrous first half of the year and at a time when the economic scenario in developed countries is deteriorating, caution will encourage an exit from risky assets in anticipation of a lull. But is caution always a good adviser?

Laurent Denise, Chief Investment Officer

Time plays a key role in stock markets

Laurent Denise

Fears that the developed economy will slide into recession have been exacerbated recently as the US manufacturing ISM index stood at 53 (56.1 in May) due to a decline in new orders and employment. In equity markets, the S&P and European indices are down about 20% since the start of the year. So after this significant decline, the question is whether the market is rewarding enough risk today.

IN THE USA, we assign a 40% chance of a recession (30% mild recession, 10% severe recession) and a 60% chance of an economic slowdown over the next 12 months. In the case of a recession avoidance scenario, we believe the market has strong recovery potential. Let’s look at earnings dynamics over the next 12 months.

We have already pointed out that profit margins in the US are unusually high and will decline over time. However, we believe that these adjustments will not occur as quickly as investors currently expect. Indeed, in the long term, the evolution of the results of companies included in the S&P500 is mainly determined by the information technology sector. However, the technology sector is currently dominated by natural monopolies, companies that benefit from network effects and significant economies of scale. Tighter regulation will weaken their power over time, but it will likely be a slow process.

Also, in the long run, the upward trend in profit margins outside the tech sector is less impressive. The slowdown in the economy is accompanied by falling prices for industrial and agricultural raw materials, which allows companies in defense sectors with solid gross margins, such as agri-food or beverages, to maintain reasonable margins. On the other hand, it is true that companies in sectors with low gross margins, such as distribution or building materials, face the dual challenge of managing limited pricing power and a likely drop in volumes.

Overall, U.S. S&P 500 margins are expected to decline but remain at reasonable levels over the next 12 months.

In Europe, the fall of the euro clearly supports exports and will limit the decline in revenues in the second quarter. The decline is likely to be felt in the third quarter. But the worst doesn’t have to be here either, because companies are now confirming full order books and a strong ability to adjust their prices to largely offset input inflation. Possible social unrest and wage increases can be expected, but the effects will only be felt later this year or even 2023. The situation in Ukraine remains the main risk for Europe. The cessation or continuation of the reduction in gas supplies may call into question the evolution of the company’s profit dynamics.

Finally, in equity markets, we are seeing valuations starting to factor in high-stress scenarios. If it is too early for a significant change in position, then the entry points are close.

Still a little early on credit

High yield spreads mean that the market expects a default rate of 7-8% over the next 12 months. In the worst case, the rating agency Moody’s estimates it at 6%. In March 2020, the market estimated it at 12%. Thus, part of the risk is clearly related to prices. It should be noted that at present the absolute rate of return is above 7.50%. However, historically at this level, the probability of receiving a positive return over the next 12 months is more than 80%. In addition, the 7.5% rate creates enough carryover to support an additional spread widening of around 250 basis points… i.e. to the highest levels reached 2 years ago.

In conclusion, we believe that the High Yield market needs a final capitulation in order to replace the last weak hands (opportunistic buyers) with investors with a more strategic vision. It will then reach a sufficient risk premium to stabilize and return to solid fundamentals.

Close to entry points

We are a little more constructive in early July. Of course, macroeconomic indicators are not good news, but the divergence of monetary and fiscal policies in China and Japan should make it possible to limit the slowdown in global growth. The resilience of societies is impressive. But more consumer stability will be tested. Even with an abundance of savings, the least privileged categories and the largest part of the population suffer from a severe decline in their purchasing power. Storm or storm on consumption? It is hard to say.

However, we are approaching entry points in both the stock market and the high-yield market. Risks remain, of course, but compensation already partly reflects many uncertainties. The low liquidity of the summer months could trigger mini-market shocks that could be used for more substantial repositioning.

In the meantime, we wish you a great summer.

2022.07.22.Our current beliefs by asset class

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The views expressed in this document are in line with the market expectations of ODDO BHF ASSET MANAGEMENT SAS at the time of publication of the document. They are subject to change depending on market conditions and cannot in any way incur the contractual liability of ODDO BHF AM SAS. It should be recalled that past performance does not predict future performance and is not constant over time. Before investing in any asset class, potential investors are strongly advised to learn in detail about the risks that these asset classes are exposed to, in particular the risk of capital loss. Investments must be made in accordance with the investment objectives, the investment horizon and the ability to withstand the risk associated with the transaction.