Markets shift focus from Price to Earnings

Market Development: In May, the MSCI World Index (total returns in USD) remained largely unchanged (+0.1%), the EURO STOXX 50 (net returns in EUR) declined 0.8%, whilst the S&P 500 (total return) also ended the month roughly flat (+0.2%).

Fund Commentary
13 Jun 2022

Market Development: In May, the MSCI World Index (total returns in USD) remained largely unchanged (+0.1%), the EURO STOXX 50 (net returns in EUR) declined 0.8%, whilst the S&P 500 (total return) also ended the month roughly flat (+0.2%).

The Dollar Index (DXY Index) retreated 1.17% following four consecutive months of gain, whilst the generic 30Yr Treasury yield increased slightly from 2.99% to 3.04% in contrast with a decreasing short end (2.82% from 2.96% on the 5Yr), and the VIX retreated from 31.66 to 24.40.

Equity markets remained under pressure for most of the month as investors continued to digest the Federal Reserve’s measures to tame inflation. Investors saw another leg down materialise in equities in the first half of the month.

Green shoots on the Chinese COVID front, reassuring corporate results in a few Consumer Discretionary categories and an alleviation of the short to medium end of the yield curve supported end-of-month dip buying. Oil’s continued push towards higher levels and a lack of progress on the Ukraine-Russia front remain key overhangs, at a time when questions of a growth slowdown abound.

As signs pointing toward an economic slowdown are beginning to emerge, investors are raising the counterintuitive question of whether we are entering a market where “bad news is good news”, i.e. whether the current financial tightening and slowdown in the economy could alleviate the pressure on equity market valuations. Indeed, early signs of an inflation stabilisation seem to be appearing in certain categories, albeit with pain likely in the future.

Housing: while new home sales dropping materially below expectations and housing under construction approaching a 20-year high certainly shows signs of a peak, the 30-year mortgage rate moving from 3.3% to 5.3% YTD has had an impact. With household financial assets having reached their highest proportion of equities in decades, the wealth effect is likely to retreat sequentially as well, leaving inflationary pressures from further acceleration in discretionary spending on a downtrend.

Whilst employment, a lagging economic indicator, remains strong, we are beginning to see anecdotal evidence of a reversal of trend in what used to be the “hot” job markets, including technology. That said, and to muddy the overall picture, energy and food prices remain high and ascending, as a number of supply chain issues, including refining bottlenecks, broadly destabilise the equilibrium and impact prices.

For energy, the mathematical reality of year-on-year comparisons makes the current trajectories likely / hopefully hard to maintain, particularly in the context of slowing aggregate GDP growth.

Will this alleviate the pressure on equity market valuations? The current correction has until now, largely been an adjustment of the price, or valuation, of financial assets dictated by the principal component, interest rates.

The price of capital increasing requires higher hurdle rates for value creation, dramatically turning the tables on those companies built upon the assumption of cheap, and sometimes limitless, capital. Any improvement on the interest rates side, as we have seen this month, should thus theoretically help.

The nuance is that the monetary tightening’s successful slowdown of the economy shifts the debate to the “E” of the “P/E” ratio. Simply said, while multiples might arguably be closer to fair on current expected earnings, a true economic slowdown would force downgrades in near-term earnings.

We believe this narrative is a key force behind May’s price action, as best illustrated by the sensitivity of markets to the earnings announcements of Target, showing slowing sales and compressing margins, and Snap, showing a significant miss on advertising revenue compared to its own recent estimates.

While the S&P drawdown reached 20% on an intraday basis on 20th May, below the indices, the reality is more nuanced and signs of long-term opportunity could start to form. For example, as a group, Biotech has rarely traded this cheaply, with a record number of companies trading below their cash levels according to experts. US Software, trading above 15x revenues only a few months ago, is now broadly back to the longer-term average of 5-6x revenues.

Reasonably secure merger arbitrage deals have seen spreads reach rare wides, while some companies are launching significant new merger operations to capitalise on current prices (e.g. Broadcom, DSM). All in all, while the earnings cycle takes over from valuation, we view the environment as approaching levels where bottom-up opportunities could become more pronounced.

Market Outlook

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 signs of abating for now, the perspective of softer demand has relieved the pressure on the forward rates curve, a positive for valuations all else being equal.

That said, things are rarely equal, and pressure is now on companies’ earnings trajectory amid a softer economic backdrop. In our view, such an environment reinforces the importance of selection, with stability and economic resilience as key.

Portfolio Development

The Sturdza Family Fund‘s NAV gained 0.38% during the month (A USD class), reflecting positive overall performance by underlying investments during a tumultuous month.

In terms of contribution, VMware led the way (+20bps), followed by Electronic Arts (+19bps), Comcast (+13bps), Schlumberger (+9bps) and Autozone (+8bps). On the detractor side, Intercontinental Exchange (-12bps), was followed by Asahi (-11bps), S&P Global (-10bps), Teleperformance (-6bps) and Medtronic (-6bps).

VMware’s contribution was the result of Broadcom announcing its intention to take over the company for a significant premium to the last traded price. We understand Broadcom’s desire to acquire such a critical piece of software infrastructure at a discounted price. The desire to engage, even at this deal size ($70bn+ enterprise value) is further evidence of VMware’s attractiveness to shrewd operators such as Broadcom’s CEO Hock Tan.

Electronic Arts also rebounded nicely, based on strong earnings and reassuring guidance supporting the view that this leading videogame publisher remains the beneficiary of structural growth and protected by a competitive moat.

Finally, AutoZone’s performance is noteworthy against a difficult Consumer Discretionary environment, as evidenced by Target. The company’s strong results outperformed expectations on all key metrics, and management’s continued growth initiatives underscore the business’ ability to expand without sacrificing its defensive credentials.

In line with our outlook, the Fund was more active than normal, with an eye on rebalancing towards more economically defensive businesses. We exited the equity positions in Brunswick, Installed Building Products and STMicro; and reduced the exposure to Blackstone and TE Connectivity.

We added weight to Boston Scientific, Cooper Companies, Electronic Arts and to our small energy-related investments (SBM Offshore, Schlumberger and Tenaris). Finally, we took some profits on Centene, UnitedHealth and Constellation Brands, great companies that had become significant weightings.

The equity allocation increased slightly in May as our put-option strategy enabled us to add small increments in a few of our existing equity holdings. The Fund also sold, and hence realised the profit, on some of its protective puts on the US market at attractive levels.

Finally in early May, on the fixed-income side, we increased exposure towards 3-5 Yr Treasuries in order to lock in attractive yields, in line with our belief in a much more attractive risk-reward setup on this part of the yield curve.

This view, combined with a widening of spreads on investment grade corporates, enabled us to opportunistically take a first step in the IG corporate market on first-rate issuers (e.g. AutoZone) and locking-in attractive yields on 4-5 Yr maturities. As such, the duration of our fixed-income book (including cash / money market) has slightly increased, from circa 1.5 to 1.8.

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.

Adam TurbervilleAdam Turberville
+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 01/06/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.