Saturday, January 28, 2023

Investing in 2023: Equities still offer value in tough times

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The shocks that hit financial markets in the past year have made many forecasters wary about making bold calls for 2023.

After all, who predicted the impact of Russia’s invasion of Ukraine, or China’s ham-fisted mismanagement of the pandemic, let alone the fiasco that was the brief premiership of Liz Truss?

Even among those who correctly saw that rising inflation would push up interest rates in 2022, few predicted the epic surge in bond yields that saw the rate on 10-year US Treasuries double to 3.5 per cent and more than triple on UK government bonds to 3.3 per cent.

Equity markets have had a less dramatic year but end it in some disarray: while the FTSE 100 is broadly flat for 2022 so far, the S&P 500 is down by nearly 20 per cent and the Nikkei 225 by about 6 per cent. The aggregate numbers conceal huge sectoral shifts, with fossil fuel producers jumping ahead, while tech stocks — the darlings of the previous decade — plunged. The Nasdaq tech-oriented index trades about 33 per cent down, year to date.

For the year ahead, the main visible financial challenge is inflation, running at more than 10 per cent in the UK. Investors need to protect the value of portfolios in real terms in what are widely predicted to be volatile markets. Sticking to cash is most unlikely to succeed, since interest rates have not risen nearly enough to match inflation. So for many advisers the answer is to stay in equities, despite the dangers.

“You can take a cautious view of the world and still be fully invested in equities,” says Simon Edelsten. “You just choose equities that can cope with a difficult view of the world. This isn’t the time to take risks.”

Edelsten, a fund manager at Artemis Fund Managers, is speaking at the annual FT Money investment lunch, where we chew over the prospects for 2023 as we munch on FT sandwiches. We are joined by Anna Macdonald of Amati Global Investors and three FT finance writers — Moira O’Neill, Stuart Kirk and Martin Sandbu.

How big is the inflation threat?

We agree that the economic outlook is bleak, with the IMF predicting growth of 3.2 per cent for 2022 and 2.7 per cent for 2023 — the weakest forecast since 2001 except for the 2008 global financial crisis and the worst stage of the pandemic. “We’ve started a pretty steep slowdown,” says Sandbu, with recession “certain” in the eurozone and the UK, and the US perhaps avoiding one by a slim margin.

What concerns the panellists most is how central banks will handle inflation. If they raise rates too slowly, inflation could spiral higher; if they press too hard they risk aggravating the economic slowdown. Higher than expected inflation is generally bad for bonds but not necessarily for equities since some companies — such as big operators in essential industries — can pass on cost increases.

Macdonald says the surge in energy costs — especially in Europe — compounds the central banks’ problems, making it harder to sort out short- and long-term inflationary pressures. “The Fed is clearly going to want to get inflation under control. And that might be at the risk of going a little bit too far,” she warns. She thinks early signs of price increases easing are already emerging. “I think we are starting to see some data points that mean inflation is probably going to start washing through.”

Sandbu, the FT’s European economics commentator, says “it’s still perfectly plausible” to see the inflationary surge as the result of an “unfortunate series of shocks” and not a fundamental economic shift. But with “good arguments on both sides”, it will be hard for central banks to get their monetary policy right — increasing the risks of further high volatility in markets.

O’Neill says that a recent opinion survey from investment platform Interactive Investor shows that, after the risk of a global recession, inflation and rising interest rates are what British retail investors most worry about.

Kirk, who is participating in the debate via video, says that higher interest rates raise the hurdle for making returns on a portfolio. “Everything’s harder. Not long ago every investment looked attractive versus zero interest rates. Now expected returns have got to be higher.”

How serious are the geopolitical risks?

Meanwhile, geopolitical risks have not lost their power to catch investors unawares. Among next year’s dangers to market stability, Edelsten cites the possibility of a hard right success in Spain’s general election, following the success of rightwing politicians in Italy, as well as the existing tensions over Ukraine, Taiwan and the Middle East. He says: “The investment outlook is fragile. It’s never good for equity investors.”

But Kirk cautions against spending too much effort trying to predict the future and too little working out how much of the risk has already been discounted by investors. What matters, he says, “is whether these things are in the price or not”.

He says with share prices well down, many negative possibilities have been discounted. But few of the potential positive surprises. “What if the Chinese Communist party decided to renew a pro-growth agenda? Or if there was a resolution of the war in Europe, for example? These things are not priced into anything and are not zero-probability events at all.”

However, one danger that Kirk thinks is definitely not in the price is the risk of a housing price collapse, especially in the UK. He suggests rising rates and recession could trigger mortgage defaults which could engulf banks in a financial crisis. “The numbers are getting worse,” he says. “And it’s not just here. I’m still surprised how little we’re talking about it. No one wants to know.”

Macdonald counters to say the housing outlook is not that bleak. She cites data showing that less than 30 per cent of UK homes are owned with a mortgage. The rest are owned outright. Also, when rates spiked on the eve of the last British housing crash in the late 1980s, 85 per cent of mortgages were variable, and 15 per cent were fixed. Now it’s the other way around. “The overall proportion of households exposed to mortgages is perhaps less than you think,” she says, and banks are better capitalised than three decades ago.

But Edelsten is not so sure, pointing out that it “only takes a small number of people” among the borrowers to get into trouble for lenders to be hit hard. “It’s always the way in finance,” he says, adding that the situation also looks tricky in some European markets, such as Berlin, which are not used to sharp interest rate rises.

Which companies can survive best?

Looking at equities, Edelsten’s advice is to back strong multinationals capable of withstanding tough times, “companies which can cope with inflation and pass it on, companies with enormous pricing power right around the world”.

He particularly likes automation companies, which account for 20 per cent of his fund, because they offer businesses a way to mitigate the impact of inflationary pay rises. “Orders are going through the roof,” he says, as companies respond to inflation, labour shortages, disruptions to global supply chains and political threats to globalisation.

Macdonald warns that such well-placed companies are often highly valued in stock markets. “There are some wonderful companies, with economic moats around them and barriers to entry [into their markets]. But they’re expensive.”

Line chart of Percentage change (local currencies) showing Equities struggle in tough times

Which stock markets will do well?

In terms of geography, one place where the panellists see value is the UK, precisely because many international investors have shunned it, especially since the 2016 Brexit vote. O’Neill says British wealth managers in a recent poll from the Association of Investment Companies put the UK near the top of their list of target countries. Macdonald adds that the increases in private equity groups and corporates making British acquisitions shows “that selectively there are excellent assets”. 

Sandbu likes higher-income emerging economies, on a long-term basis, including countries in eastern Europe and better-off states in Asia and Latin America. Edelsten plumps for Asia, especially Japan. A long-term fan of the US, he now thinks American markets are overpriced — not least because of the US dollar’s ascent — and he can “get much better value for money in other parts of the world”.

Kirk also favours Asia, including Japan, arguing that the risks in China, both immediate (the Covid pandemic) and in the long term (the transition out of export-led growth) are well discounted in the markets. Meanwhile, the region’s advantages — notably the emergence of modern, well-run companies — are underpriced in comparison with western rivals.

What about energy?

As for sectors, the panellists are keen on investing in energy, but selectively. The surge in oil and gas prices has boosted fossil fuel producers and prompted a reassessment about the green energy drive. “Net zero will not go away, and shouldn’t go away,” says Edelsten. “But there is a need to be more pragmatic.” And that pragmatism includes boosting non-Russian gas supplies to reduce western dependence on Russia.

Edelsten invests in oil and gas services companies, notably the US groups Schlumberger and Halliburton. Their activities include improving gas recovery and reducing methane leaks in existing fields, so helping to make the industry more environmentally-friendly, he says. “Although the sector is demonised, these companies are potentially part of the solution.”

Macdonald, who specialises in smaller British companies, has a similar play with an investment in Ashtead Technology, a subsea equipment rental business, which serves both oil and gas, and offshore wind groups.

Sandbu points out that rising government investment will help businesses that position themselves well, whether in energy or other infrastructure. “Investors will not want to follow the money, but rather front-run the money and see where governments are going to put in a lot of money to stimulate . . . a lot of them will be green projects.”

Edelsten agrees. He cites the example of batteries, required in vast amounts to store network electricity. He likes Panasonic, the Japanese electronics group that is the globe’s largest battery maker, not least because it is, in his view, “one of the cheapest big stocks in the world” and overlooked by other investors. “There’s always stuff out there for stock pickers.”

Kirk reminds us to keep focused on shareholder returns. He says it’s perfectly possible for companies to be on the “winning” — green — side of the energy transition and lose money because the market is so crowded that margins are squeezed to nothing. Equally, the eventual “losers” — fossil fuel producers — can be great investments because they manage their exits profitably. He says: “What matters is the return to shareholders. Tobacco is a classic example: flat or falling volumes. [It’s] the best performing sector in the past decade.”

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Tech: dead or alive?

Panellists are wary of tech, in the sense of the young start-up companies that ramped up high valuations in the recent boom. Edelsten argues that the tech bulls may still not have surrendered and sold up, as committed investors can struggle to admit they were wrong. “What we call capitulation comes very hard.”

But with prices well down across the board, he sees value in established tech groups making good profits. He likes industry veteran Microsoft, for example, and TSMC, the Taiwanese chip group. But he still finds online retailer Amazon and financial management provider Workday too expensive.

Macdonald argues that it’s always worth looking for good-value smaller companies. She favours Kainos, a UK-listed tech group that works with Workday. “There’s still plenty of opportunity there, but it’s very bottom up.”

O’Neill says UK retail investors who piled into US tech both directly and through investment companies such as Scottish Mortgage Investment Trust now “need to reassess” their exposure. “We must reimagine where the opportunities are in tech now because it’s all in the back office, rather than the flashy things that you immediately think of when you think of tech like Amazon and Google.”

Is healthcare a good, safe bet?

Looking elsewhere, O’Neill also likes healthcare, as a reliable investment since ageing populations will increase spending even in tough economic times.

Edelsten agrees. He favours companies in high-quality, affordable public health, such as US private insurance groups and Pfizer, which he regards as underpriced despite its star role in producing Covid vaccines. But he shies away from businesses “which are just inventing very expensive, very clever things to cure very small numbers of rich people”.

Macdonald, as before, finds a British niche business that fits the bill — Craneware, a software group that draws its revenues from US healthcare providers.

Kirk makes a broader argument, urging investors to look at established groups — especially “boring industrials” — that are boosting profits by improving their asset utilisation, otherwise known as asset turnover or the revenue generated by a given assets total. “I don’t think asset turnover gets anywhere near the publicity that it should, but it’s just as important as margins in driving ROE [return on equity].”

In other words, as our panellists have repeatedly said, there will still be value in equities in 2023, but you’ll need to look hard for it.

Numisteamone

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