There is, we think, more downside to US — and global — stocks despite having suffered the worst first half-year selloff since 1970, according to Dow Jones Market Data. The bond market, often seen to be the ballast for riskier stocks, fared no better, posting the worst start to the year in decades. The selloff in both stock and bond markets this year has been steep, gaining steam rapidly as inflationary pressures mounted, particularly after Russia’s invasion of Ukraine. This, in turn, has forced the US Federal Reserve to pivot to a far more aggressive stance to combat inflation, which is currently running at highs not seen since the early 1980s.
We now believe high prices will persist for longer, not only because of the prevailing pandemic- and war-driven supply disruptions and shortages — which are taking longer than expected to unwind — but also due to the longer-term fallout, specifically the geopolitics.
Globalisation in the past four decades was driven largely by cost optimisation, underpinned by the relative free flow of capital and trade — at the expense of resilience. And it is deflationary, which fed consumerism in the developed world and created immense wealth for capital owners. This trend is now reversing — and will continue to reverse.
Rising tensions and trade conflict between the US and China caused the first rift. The pandemic then highlighted the importance of domestic supply chains for critical medical supplies (such as masks, gowns, gloves and ventilators), computer chips and a range of other goods. The Ukrainian war further exposed the world’s willingness to weaponise almost anything from finance and the US dollar to food, energy, trade and investments.
These developments are forcing countries to refocus on national security and self-sufficiency for food, energy, technology and critical materials. It will lead to more protectionism, trade barriers and even outright export bans on key commodities and materials. We are not portending the end of globalisation, but we see it changing — from unfettered globalisation to “globalisation with friends and allies”. That the latest North Atlantic Treaty Organization (NATO) summit included heads of states of Asian countries, for the first time, is a clear signal by the US and the West that the world will once again be divided. Small countries will, increasingly, be forced to take sides.
In short, geopolitics, national security, localisation and self-sufficiency will result in shifts in trading partners and investments (re-shoring and friend-shoring). And that will almost certainly translate into lower productivity and higher costs — and prices — given the necessary sub-optimal allocation of resources. Add in higher wage demands, and they all point to the next 20 years of reversal from the gains of globalisation. The possibility of self-inflicted stagflation on Western countries, feeding into emerging countries, seems the most likely scenario.
Prices will eventually stabilise at higher than originally anticipated levels, even if inflation rates come off the current blistering pace. In the long run, we still expect technological advancements and innovations to be strong deflationary forces. The Fed appears committed to fighting inflation. That means it will keep front-loading interest rate hikes until there is sufficient demand destruction to curb price-wage increases — whether or not it manages a soft landing or to tip the economy into recession. Positively, US corporates and households are in comparatively good financial shape, many still sitting on big buffers of savings from the pandemic. And since all these pitfalls have been extensively discussed and written about, people are able to plan ahead. This is probably why the market selldown thus far, though steep, has been fairly orderly. There is little panic. In fact, many investors are simply waiting to jump back into the market, which is why we see the big swings (sharp rallies amid the broader downtrend) in day-to-day trading. The million-dollar question is: Have markets hit bottom? We think not.
The intrinsic value of a stock is equal to its discounted future cash-flow stream — the short form of which is the expected earnings multiplied by the price-earnings (PE) valuation (multiples over earnings that investors are willing to pay). The PE ratio is determined by risks — relative to the risk-free rate — and growth prospects. The massive bull market rally we saw (before the current selloff) was driven by both rising earnings and PE valuation expansion (due to falling interest rates, to near zero). In reverse, the current selloff, we believe, has largely taken into account higher interest rates going forward — that is, PE valuation compression. This is why richly valued high-growth stocks — with earnings further into the future — have been hardest hit. According to data provider FactSet, valuation for the Standard & Poor’s 500 index has fallen about 25% to 15.8 times forward earnings currently, from more than 21 times at the start of the year.
Expected earnings growth for S&P 500 companies, on the other hand, has actually inched higher — from 9.4% to 10.2% for 2022 and 9.1% for 2023. This is far too optimistic, even accounting for the huge jump in earnings for the energy (due to high oil prices) and industrial (driven mainly by airlines turnaround) sectors. The current-year profit margin is estimated at 13.3% and rising to 13.9% in 2023, the highest since the global financial crisis (see Chart 1).
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We are not experts on US company earnings by any means. But based on our experience as analysts, it is highly improbable that margins can keep rising to record-high levels in the prevailing environment — as consensus forecasts. Rising costs amid a demand slowdown must hurt profits and margins, even for consumer staples, where demand is generally resilient. Heading into 2023, the bite from higher prices and interest costs will be more evident, for both businesses and consumers.
There are already signs of a slowdown in retail and housing, as consumer confidence has dropped and some businesses have started to scale back hiring and reduce inventories. Therefore, it is more realistic that earnings growth could end up flattish, at best, and contract, at worst. And this is something that market prices have yet to fully reflect, based on the magnitude of declines so far. The S&P 500 index is down by just about 20% from its peak (at the time of writing).
Based on our back-of-the envelope calculations, if the S&P 500 net profit margin falls to 11% in 2022 and 10% in 2023, it will cut current earnings consensus by 18% and 28% respectively — that is, earnings growth will be pared to -10% and -5%. The S&P 500 could fall another 17% to 27%, assuming yields top out between 3% and 3.5% (see Table). Certainly, there will be some trade-off — as the economy weakens, the acceleration in prices and yields should start to taper off, perhaps taking some heat off growth stocks. We cannot know exactly where and when the bottom will eventually be. The point is that further downside from hereon is highly probable.
Negative guidance on outlook from Amazon.com, Walmart, Target Corp, Nike and, most recently, chipmaker Micron Technology is a leading indicator of a broader softening in consumer demand resulting in excess capacity, inventory build-up and price discounting (and margins compression). Why, then, are analysts not revising down their earnings forecast to be more reflective of the current environment? Perhaps there is too much uncertainty and they are waiting for more clues to quantify the impact and/or some actual results to extrapolate from. The impact of rising costs, the extent to which companies can pass them on to customers and the effect of higher prices on demand can be very difficult to predict.
Or the answer could be far simpler — it is in their own interest to keep money invested, since income is based on commission. FactSet notes that “despite higher inflation, rising interest rates, military conflict in Ukraine, fear of recession and stock price declines, analysts continue to have an unusually high number of ‘buy’ ratings on stocks in the S&P 500”. Indeed, the number of “buy“ calls always outnumber those of “sells“, whether in a bull or bear market. Analysts and fund managers have vested interests in talking up markets.
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Expectations for further short-term market weakness is the main reason why we have been switching out of US stocks for the Global Portfolio. Over the past two months, we have disposed of Microsoft Corp, CrowdStrike Holdings, Bank of America Corp and Amazon, all of which are still fundamentally sound companies. We are staying invested, though.
As noted previously, we recycled part of the proceeds into several Chinese stocks. Last week, we added Chinasoft International to the Global Portfolio. The Chinese stock market had fallen much earlier — thus, valuations are more attractive — and is now further along the recovery path. Also, we think China will do more to stimulate the economy in the near-medium term, including relatively loose monetary policy — contrary to the tightening cycle in the US. Indeed, as China-based stocks gain momentum, we are seeing more bullish commentaries from analysts. This is quite the turnaround for a market that was deemed “uninvestible” mere months ago. As we like to say, narratives follow the market.
For nearly two years, during the pandemic, when the Fed cut interest rates to near zero, stocks were the TINA (there is no alternative) trade. This is fast changing. As noted, bonds too have had a terrible 1H2022, given that prices have had to adjust for the very steep rise in yields. Yields for the benchmark 10- year US Treasury rose nearly seven-fold from a low of about 0.5% to as high as 3.5% in mid-June. Yields have since fallen back some — as odds for a recession rose — and are currently trading just a hair’s breadth under 3%.
Having risen this fast, yields may be nearing the top, in which case, prices (which fall as yields rise) are also much closer to the bottom, relative to stocks. The difference in yields between stocks (earnings yield is the inverse of PE) and bonds has narrowed as bond yields rose — and could fall further when earnings drop, making bonds more appealing (see Chart 2).
Indeed, at current yields of around 3%, US Treasury is looking attractive again for income-seeking investors amid the volatility in stocks — and a relative safe haven in recession, with fixed income returns. Our investment in the iShares 20+ Year Treasury Bond ETF has held up comparatively well in the market selloff, and we think it will continue to outperform stocks in the near term.
The Global Portfolio closed marginally higher, up 0.1%, for the week ended July 6. This was better than the MSCI World Net Return Index’s 0.5% loss. The best performing stock last week, by far, was Yihai International Holding, whose share price rose 10.1%. The iShares 20+ Year Treasury Bond ETF (+0.9%) and Guangzhou Automobile Group Co (+0.7%) were the other two gainers. At the other end, Airbnb (-5.2%), Alibaba Group Holding (-2.3%) and Commercial Bank for Foreign Trade of Vietnam (-2.2%) were the biggest losers. Total portfolio returns since inception now stand at 27.6%, trailing the benchmark’s 31.6% returns over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
