Market Development: In June, the MSCI World Index (total returns in USD) declined 8.66%, the EURO STOXX 50 (net returns in EUR) gave up 6.01%, whilst the S&P 500 (total return) also ended the month in the red, returning -8.39%. The Dollar Index (DXY Index) gained 2.88%, whilst the generic 30Yr Treasury yield climbed from 3.05% to 3.19% and the VIX increased slightly, from 26.2 to 28.7.
After a welcome lull in May, equity markets went into a sharp correction in June following the publication of higher-than-expected US inflation figures. The Federal Reserve’s response was swift with a 75bp rate hike.
As mentioned in our last commentary, with the debate now focused on earnings and less so on multiples, Mr Powell’s comments were worrisome because of the intention they revealed: to slow down the economy, at the risk of causing a recession. The equity market’s response, therefore, followed this logic, correcting equity prices further for the more cyclical Energy sector rather than Technology, a real change in trend.
In line with these dynamics and on the eve of the publication of quarterly results, the steady increase in analysts’ explicit earnings expectations is notable and diverges from investor sentiment. Indeed, while the US market correction has reached around -20% to date, it has so far taken place in the context of an increase in the US real 10Yr rate from -1.04% to +0.65%, impressive and rare quanta. In other words, while valuation multiples now reflect higher real interest rates, these multiples seem to be based on consensus earnings expectations, which remain surprisingly upbeat.
Looking at this closely, if stock performance can be broken down into earnings per share growth, valuation and dividends, the analyst consensus is indeed surprising when it comes to earnings per share. Its key component is the profit margin, and cost inflation coupled with weakening demand would undoubtedly put it under pressure.
Remember that this profit margin has grown from 9.4% to 11.6% in the US, and from 6.5% to 8.8% in Europe, from 2020 (pre-COVID) to date (source: Goldman Sachs). Let us also remember that Producer Price Indicators (PPI) are currently outpacing Consumer Price Indicators (CPI), indicating a divergence between cost and revenue trajectories and that historical statistics show us that if there were to be a recession, it would not bode well for margins, which would decline by 0.8% to 1.8% according to past episodes (source: Goldman Sachs).
This divergence between analysts’ earnings expectations and the market’s palpable concerns only increases our belief in the “quality” style equities. The intensity of the correction in this style of management is historical, and a consequence of a complex and rare inflationary dynamic, leading to a monetary policy that is out of step. That said, the current situation, inflationary in the short term and possibly recessionary in the medium term, significantly increases the probability of pressure on margins, in remarkable contrast to this confident consensus.
The so-called “quality” companies will make the difference due to their prototypical characteristics: low debt; ability to raise prices and defend margins; low-cyclical end markets; and stable growth. While these attributes have attracted valuations that are sometimes too rich in a low-interest rate environment, it seems that the correction has now taken place.
Our interpretation of the environment suggests that their strengths should once again become an important source of differentiation in light of the risk to the cycle and to margins.
As mentioned last month, looking forward, signs of a macro slowdown in the US are increasing, as key drivers of disposable income and wealth – including Real Estate and equities – face the rise in inflation and the cost of capital operated by the Federal Reserve.
While pressures from supply chains and energy show little sign of abating, for now, the prospect of a recession or stagflationary episode is pushing markets lower. With the second quarter earnings starting in July, pressure is now on companies’ earnings trajectory.
In our view, such an environment reinforces the importance of maintaining some defensiveness, while focusing on companies exhibiting stability and economic resilience.
The Sturdza Family Fund returned -4.16% during the month, reflective of the above-mentioned correction in most asset classes.
In terms of contribution, our protective put options provided a welcome 38bp contribution. For equities, Alibaba led the way (+12bps), followed by Prosus (+10bps), Centene (+8bps), UnitedHealth (+7bps) and Autozone (+6bps).
On the detractor side, Air Liquide (-22bps) was followed by Meta (-22bps), Global Payments (-19bps), Mastercard (-17bps) and Schlumberger (-16bps).
In line with our outlook, the Fund remains active, with an eye on rebalancing towards more economically defensive businesses and looking for asymmetric opportunities. Our protective put option Portfolio was harvested at the June option expiry, while the Fund’s net equity allocation remains highly defensive.
We exited our positions in Blackstone, Becton Dickinson and TE Connectivity, and restructured our exposure to Moody’s and S&P Global towards lower sensitivities.
We initiated small exposures to L’Oreal and Edwards via put options, continuing to profit from high levels of volatility mid-month. Finally, on the fixed-income side, the Fund increased its exposure towards the IG corporate market on first-rate issuers, locking-in attractive yields on 4-5Yr maturities.
As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio. Please do not hesitate to contact us for further information.
+44 1481 742380
The views and statements contained herein are those of Banque Eric Sturdza SA in their capacity as Investment Advisers to the Fund as of 14/07/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.