Where is the value in equities in the current climate?

Jim Caron, co-chief investment officer for the global balanced risk control team at Morgan Stanley Investment Management, says that in a world where inflation is likely to be persistently higher than the level to which many investors have become accustomed, “rigidities” in economies are likely to have a major impact on how different markets perform.

He says the US is the market with the fewest rigidities, which, in his view, means that it will outperform rival markets despite the valuations.

The rigidities Caron is referring to include the fact that: “In Europe, it’s harder to hire and fire employees. The energy market is different as it relies on imports, unlike in the US, and many parts of European economies are more heavily regulated.

“Inflation is going to be part of the landscape globally for some time to come. We are seeing reshoring of manufacturing and deglobalisation, both of those things are long-term inflationary trends, while the money supply has also expanded meaningfully,” he continues.

“In that climate, the hurdle rate [that is the percentage annual return a company needs to make in order to be an attractive investment] is higher, and those rigidities make it harder for companies in Europe to achieve those returns. It’s much harder to start a business in Europe, and they risk being left behind in areas such as artificial intelligence.

“When there are trade disputes impacting these areas — for example, between the US and China — the US has shown an ability to negotiate.”

In terms of the the types of stocks and sectors Caron believes can perform well in such a climate, he says companies in the telecoms sector are likely to be able to maintain pricing power, as are commodity companies and businesses in the financial services sector. 

Growing pains?

John Bilton, head of global multi-asset strategies at JPMorgan Asset Management, agrees that the ability to maintain profit margins will be a key part of investment returns in the coming period. 

His view is that nominal gross domestic product growth — that is, growth which includes inflation — will remain high, but the share of this growth that translates into net profit for companies will be lower than has been the case in the past, as costs will be higher and margins lower. 

Inflation is going to be part of the landscape globally for some time to comeJim Caron, Morgan Stanley Investment Management

Bilton says the global economy is transitioning, not merely from low to high interest rates, but also to a period where fiscal spending will boost the outlook for the industrial parts of the global economy, and to newer energy sources and a transition to a period where the full impacts of emerging technology are felt.

He says companies that are not capital-intensive — meaning they can operate without needing to raise new capital — will be the equities that find favour with the market in the coming period. 

Anthony Rayner, who jointly runs about £800mn across a range of multi-asset funds at Premier Miton, has long believed that inflation would remain higher for longer, and, as such, has not had much exposure to US technology stocks as he feels they would suffer for being “long-duration” assets at a time of higher inflation.

This is relevant because technology companies are usually expected to generate the bulk of their returns in the future, rather than right now, and so are essentially competing for capital, not just with other equities but with bonds, which offer a return over multiple years that is visible. 

So if bond yields rise, then the expectation is usually that technology shares perform poorly.

Rayner says that with yields having “moved quite a bit upwards, maybe towards their peak, we have added a little bit to technology stocks in the US as a result”.

His view on the bigger picture is somewhat similar to that of Caron, as he feels the global economy is becoming “desynchronised”. He says that following an extended period of time where monetary policy, the pandemic and then monetary policy again, economies will now begin to perform radically differently from each other.

Both Caron and Rayner cite the example of Germany’s current economic downturn, relative to recent strong GDP growth posted by the US. 

Machine learning?

Rayner’s reaction to these dislocations is, in addition to owning more US technology stocks, to buy “consumer staples” — that is, stocks for which demand is relatively constant and so not exposed to the economic cycle.

These stocks would also be expected to do well in an environment where bond yields have peaked. This is because the income from consumer staple-type stocks is viewed by many market participants as being similar in terms of reliability to that of bonds. 

So these types of equities are also competing with bond yields for capital, and if bond yields have peaked that should benefit the equities which most resemble bonds.

The companies with less debt and those who have funded themselves such that they do not need to refinance in 2023 and 2024 are clearly in a better positionVincent McEntegart, Aegon Asset Management

Rayner adds that Japan may represent diversification within an equity portfolio, as a combination of currency weakness, the very different inflation outlook, and the travails of the Chinese economy alter investor sentiment. 

The Japanese stock market has returned more than 20 per cent this year. 

Vincent McEntegart, who runs Aegon Asset Management’s Diversified Monthly Income Fund, takes up the point made by Caron around higher returns on cash and bonds acting as a “hurdle” for equity investing.

He says investors typically want an additional return from equities to that offered by bonds or cash as compensation for the additional risk being taken, this is known as the equity risk premium. 

McEntegart notes that “the equity risk premium is low” at present, but he has increased his exposure to equities in his multi-asset fund to 32 per cent from the previous 28 per cent as a result of cheaper valuations.

Thirty per cent represents a neutral allocation to equities in his fund, so at 32 per cent he is slightly overweight.

‘Quality companies’

The equity exposure McEntegart has is concentrated in what he calls “quality companies”, by which he means businesses with relatively low levels of debt.

He explains: “We have about 25 per cent of the equity allocation in a range of technology equities. And in this market, some tech equities are behaving like defensives. Rising interest rates and bond yields mean that the cost of capital is rising.

“The companies with less debt and those who have funded themselves such that they do not need to refinance in 2023 and 2024 are clearly in a better position. In contrast, companies that we are not keen on have a lot of debt and where debt needs to be refinanced near term and/or where debt is in the form of loans [where the interest payments rise and fall with moves in base rates].”

David Thorpe is investment editor at FTAdviser