Rising real interest rates has put pressure on growth stocks, while cyclicals have been hit by the negative outlook for economic growth as speculation mounts that the US economy could enter recession. This is on top of the ongoing war in Ukraine, which sadly shows no sign of a resolution anytime soon, and China is going through a series of regional lockdowns due to an increase in Covid.
In the UK, our market has held up better than many other developed markets on a year-to-date basis thanks to the relatively high exposure to oil and mining stocks. Nevertheless, I would describe this as a ‘profit warning rich’ environment because there are so many potential sources of profit warnings out there, from the top down there is a great deal of uncertainty and from the bottom up companies are having to deal with a highly challenging operating environment.
But shouldn’t high inflation, rising rates, and a slowing economy already have been priced into the market? After all, these issues haven’t materialised overnight. In a UK context, I think one thing that took the market by surprise was the Bank of England’s candidness, with its governor Andrew Bailey saying he expects a “very sharp slowdown” that will cause “hardship” for the public.2 The comments were relatively dovish when it comes to monetary policy (the Bank of England will not yet start to sell back the bonds it bought during quantitative easing, for example) but notably bearish for the economy.
That said, in my view valuations in UK domestic names are starting to look more interesting, such is the extent of the bad news that is now reflected in share prices. I consider myself a style agnostic investor, happy to hold both growth and value stocks, and recently have been selling down commodities exposure into strength and keeping a close eye on opportunities to reinvest in value stocks among consumer cyclicals on reduced valuations. The indiscriminate nature of the way in which the market has treated growth and value stocks has created these sorts of opportunities, in my view.
We are today at a junction where there is hiking pressure from central banks but also the risk that excessive activity from central banks can create a recession. Especially in the government bond markets in the US, this has already been reflected and even arguably over-reflected in valuations.
The investment grade bond market in the US has also seen underperformance. Usually, if we are heading into a big recession, high yield bonds will suffer more but this has not been the case so far, with US investment grade bonds down approximately -12% compared to -7.7% for high yield bonds. As a result. we could see even more divergence in the spread between the US investment grade market and the US high yield market, but this is very much dependent on the recession outlook. There are differences among different sectors too; for instance, subordinated financials have already priced in a lot in terms of a recession risk, with contingent capital, or Cocos,’ yields in certain European banks reaching 7%-8% with a solid fundamental profile.
Support measures for the economy are being removed, and inflation data is putting pressure on central banks to raise interest rates aggressively. However, central banks will have to be careful not to harm the recovery, which is still incomplete, especially in Europe.
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