Brighter Days Ahead?
Jun 10, 2022
Harmen Overdijk, CFA

The equity market sell-off, which saw the global equity market lose 13% and the NASDAQ 23% by the end of May, was caused by a combination of factors – a hawkish policy pivot by the Fed, the war in Ukraine, and the COVID lockdowns in China adding to supply chain disruptions.
 
We still think that the global economic cycle is strong enough to avoid a recession in the short term, especially in the U.S. The recent market correction has made equities cheaper, and valuations have discounted much of the bad news with global equities now trading at 15.3-times forward earnings, and only 12.5-times outside the US. More importantly, the forces that pushed down stock prices are starting to soften. The war in Ukraine no longer seems likely to devolve into a broader conflict, the number of new Covid cases in China has fallen, and global inflation has likely peaked.
 
Shanghai has now reopened after a two-month lockdown. The 20th Chinese National Party Congress is scheduled for this fall. In the lead-up to the Congress, it is likely that the Chinese government will move to diffuse social tensions over its handling of the pandemic by showering the economy with stimulus funds. The credit impulse has already turned higher, which bodes well for both Chinese growth and growth abroad.
 
We think we are now at a point where the outlook for stocks has brightened, and thus we have turned more constructive on risk assets again. In our view, global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. 

Another Dotcom Crash?

We have also turned more positive on tech stocks. The NASDAQ Composite now trades at a forward Price-to-Earnings ratio (P/E) of 22.6, down from 32.9 at its peak last year. During the 2000 Dotcom crash, the NASDAQ Index fell 81%. However, today’s NASDAQ Index is not comparable to the composition of the Index 22 years ago. Back then the NASDAQ was comprised of many non-profitable Internet stocks and even the profitable companies were trading at Price-Earnings ratios of above 100 times.
 
A modern-day equivalent of the 2000-NASDAQ is the GS Non-Profitable Technology Index. If we look at its trajectory, it lost almost 69% from its peak last year to its low in May. Some ETFs that invest in this space were down nearly 80% over the same period. This is comparable to the drawdown of the NASDAQ in 2000. In effect, we have already experienced another Dotcom crash.
 
Equity markets are hard to predict but we believe we are getting close to the bottom of this correction. The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months.

U.S. Households Are in Good Shape

One fear of investors today is that rising interest rates at a time of slowing economic growth will lead to a recession in the near future. The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the U.S.
 
U.S. households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. In addition, the ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the capacity to spend more.
 
Core capital goods orders, a good leading indicator for capital expenditure, have surged. The homeowner vacancy rate and existing home supply are at record lows, suggesting that homebuilding will be resilient as the housing sector slows in the face of higher mortgage rates.

U.S Rates Are Close to a Near-Term Peak

May was a good month for fixed income portfolios as bond yields retreated from recent highs. Although we believe that bond yields will rise in the coming years, we do think that the U.S. Treasury yield will not rise much beyond 3% in the next 12 months. U.S. financial conditions have tightened by enough that the Fed no longer needs to talk up interest rate expectations.
 
The latest employment numbers show the U.S. adding 390,000 jobs in May – a number that was matched by new entrants to the labor force. This shows the labor market is not as tight as feared. This lessens the risk of a wage-price spiral, and indeed average hour earnings came in at 5% again, still trailing inflation meaningfully. Lastly, three key supply-side factors driving inflation – DRAM chip, shipping container, and fertilizer prices – have all turned around from recent peaks.
 
If inflation decelerates faster than anticipated over the coming months, as we expect will be the case, the Fed’s messaging will soften further. Bond yields in the U.S. and abroad are likely to fall over the next 6-to-12 months, even if they do rise over a longer-term horizon. After increasing duration in our fixed income portfolios in April by adding 10Y U.S. Treasuries, we keep a neutral duration position.

Chinese Policy Makers Need to Make a Hard Decision

After facing strong selling pressures at the beginning of the year, Chinese stocks have started to rally in the past weeks. Investor sentiment towards Chinese stocks appears to be improving amid positive policy developments. Authorities have rolled out new stimulus measures to support the economy. Meanwhile, the pandemic situation is improving, and Covid-19 restrictions are starting to ease in Beijing and Shanghai.
 
Nevertheless, the Chinese economy continues to face downside risks. First, Chinese authorities remain committed to the zero-Covid policy. Given the highly contagious nature of the Omicron variant, authorities will likely impose new restrictions in response to fresh outbreaks for the remainder of the year. This dynamic will remain a drag on economic activity.
 
Second, policy measures have thus far been in the form of supply-side support through new infrastructure spending. Meanwhile, weak private-sector sentiment is weighing down on demand for loans. Although recent the relaxation of housing policies is positive, it is not enough to generate a strong recovery in housing demand.
 
Regardless of its form, China cannot avoid the provision of significant additional fiscal and monetary support if it wants to grow its economy while maintaining a zero-tolerance COVID policy. Effectively, it will need to restart credit creation. However, increasing debt levels is the one thing the Chinese government is generally reluctant to do but they might have no choice.

Portfolio Actions

In short, we are turning positive on equities again and have rebalanced portfolios to express this view. Within Balanced, Moderate, and Conservative portfolios we brought the asset allocation back to neutral by selling some of the bond exposure and bringing the equity exposure back to the neutral long-term allocation.
 
Secondly, we sold exposure in the global Momentum factor and allocated the cash to a global Quality factor. Many Momentum Indices were rebalanced on May 31st and have become more defensive as they invest in companies that did well in the past 6 months, and we do not want the portfolio to become more defensive at this point in time. The Quality factor focuses specifically on profitable companies, which should continue to do well in this part of the economic cycle.
 
To position portfolios for a potential rebound, we have sold the exposure to Global Real Estate, which has done well but has likely seen the peak of its post-pandemic rebound vs broader equities. Instead, we allocated 3% of the equity part of the portfolio to NASDAQ exposure, as lower bond yields will support growth stocks.
 
Lastly, we topped up positions in Clean Energy, which suffered because of its growth exposure, and China equities. We still believe in the fundamental long-term trends behind the renewable energy transition and the growth of Chinese consumer. Both market segments have underperformed in the recent market downturn, and we want to use the lower valuations to top up exposure.
 
As these are changes to our Core Portfolios, the rebalances are relatively small to ensure that the Core Portfolios continue to offer core global exposure to capital markets.
 
Our objective is to build portfolios that outperform the global benchmark over the long-term by active allocation to macro trends, tilting to exposures likely to outperform over the medium term. We are not betting the farm or short-term trading - we aim to invest in right parts of the market, not timing the market.


DISCLAIMERS & DEFINITIONS

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. 

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

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Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The index includes all Nasdaq listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures.

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