Global Equity Views 1Q 2022
Themes and implications from the Global Equity Investors Quarterly
- As the world economy gradually normalizes after the convulsions driven by the pandemic and the ensuing monetary and fiscal stimulus, we see profit growth continuing, though at a much slower pace. The return to normal carries both risks and opportunities for equity investors.
- Since our quarterly discussion the outbreak of the crisis in Ukraine has worsened the outlook. It has both pushed down growth forecasts and added yet more pressure to inflation amid higher commodity prices.
- Valuations are mostly reasonable now, but some areas of high prices remain and may still prove vulnerable to a move away from emergency monetary policy. Speculative activity within the equity markets is rapidly cooling from the frenzied levels of early last year, and in our strategies we prefer a strong bias toward better-quality companies.
Equity markets had a bumpy start to the year even before Russia’s invasion of Ukraine last month. Profit reports remain strong, but the unmistakable signs of higher interest rates ahead are putting pressure on valuations, especially for the highest and most optimistically priced companies. The speculative mood that peaked a year ago is shifting quickly. As always, we focus on understanding and forecasting long-term profitability as the way to estimate equity returns. As the impact of the COVID-19 pandemic begins to fade, we see increasing signs of normalization in our outlook for corporate profits around the world, although the pace of recovery continues to vary. Economic growth remains above trend in the U.S., and Europe was catching up but the burden of higher energy prices will hit Europe especially hard. China remains in a weaker spot.
We also see signs that the pandemic pulled forward demand in some instances, and as the world normalizes, investors could be disappointed if they had assumed these gains would prove permanent. This is especially true for some highly rated technology companies that benefited from an acceleration in online activity that many believed to be inevitable structural change. The monetary policy response to the pandemic also triggered an enormous boom in the capital markets, with frenzied trading and new issuance activity that greatly boosted the financial sector. These gains, too, are fading, although this was more widely expected and factored into valuations.
We are also closely tracking corporate costs to understand how much of the pressure on supply chains, input costs and wages was transitory (the result of the pandemic-driven surge in consumer demand) and how much will likely constitute a “new normal.” Here, the picture is complex, but broadly we expect that many input cost increases will fade and supply chains will gradually normalize over the course of 2022. (Admittedly, little has actually happened so far.) However, wage inflation is likely to be a more serious and persistent issue, especially in the U.S. Meanwhile the pressure on commodity prices has of course intensified in the past few days.
Overall, our near-term and long-term profit expectations are stabilizing after big gains in 2021. We see a much more typical path ahead, with steady but slower growth, fewer positive surprises and more disappointments than we experienced during last year’s truly exceptional profit boom. After all, that’s what normalization looks like.
Equity valuations overall look fairly reasonable to us, with equity markets in Europe, Japan and the emerging markets trading at or slightly above long-run averages. In our proprietary research model, Chinese stocks now offer the best returns we have seen for several years, although we are wary that profit forecasts are still moving lower. U.S. stocks continue to trade at a premium, while across markets we still see a high dispersion of valuations and a wider than usual premium for faster-growing companies, despite some big declines in recent weeks.
The underperformance of never-profitable companies
Last year in our Q2 note, we highlighted the market’s remarkable degree of optimism toward early-stage companies that had yet to report a profit but were nonetheless rewarded with booming stock prices and sky-high valuations. This enthusiasm peaked in the early months of last year (as it did for much speculative market activity), and since then this group of stocks has performed very poorly (Exhibit 1). Is this underperformance now behind us? Despite the severity of the declines, we are still very selective with these investments. The valuations of never profitable stocks in the aggregate still appear quite demanding at around 9x enterprise value to revenues, which is well below the peak of 18x but still about one turn higher than before the pandemic. Obviously, too, that multiple represents a still lofty premium to the global equity market at 2.4x.
The strong performance of never-profitable companies in 2020 has now unwound
Exhibit 1: Relative performance of never-profitable companies
Although investors can do exceptionally well over time by identifying winners before they have turned profitable, our research shows that this group provides more disappointments than winners and typically generates worse returns than the overall market. We also invest in these names, but selectively, and we have had success over time especially in health care. But we make sure we have a clear insight into the path to profitability, and we apply a tough sell discipline to cut our losses if we realize that our optimism was misplaced. That discipline is especially important right now as the popularity of “growth at any price” as an investment style comes to an end.
An update on ESG investing
Like most equity investors, we have thought hard about how to integrate the financially material aspects of environmental, social and governance (ESG) issues into the investment process. We recently refined our analyst-driven ESG assessment to better identify areas of improvement and opportunity, as well as distinguish the most serious issues from other, milder problems. We remain convinced that these issues are very important to our understanding of investment opportunities and risks, and also that we need to do the requisite analytic work ourselves rather than simply rely on other people’s data and opinions.
Of course, this does not mean that companies with strong ESG scores will constantly provide better returns. The highest scoring stocks in our proprietary model have outperformed in recent years. But so far, 2022 is different, with many low scoring companies performing well as the energy sector recovers (see below). Sustainable portfolios also tend to be long growth and quality factors, and underweight value. When markets behave as they have this year, these biases can detract from returns in the short run.
However, in the long term we do think that sustainability will correlate positively with shareholder returns. Companies with high scores are typically better managed, will enjoy a lower cost of capital and will attract interest from the growing assets invested in ESG-oriented investment strategies. Meanwhile after the recent market moves, valuations are better. ESG leaders in the U.S., for example, are now trading at just a small premium to the market.
The energy sector's recovery, helped by newfound capital discipline
During the early stages of the pandemic, some oil prices turned negative as demand collapsed, and the energy sector shrank to multi-decade lows as a percentage of global market capitalization. Almost two years on, the price of energy is soaring again, even before the outbreak of war in Ukraine. Energy stocks have been outperforming again, Can this last? Our research team points to one important positive factor: growing evidence of a lasting change in management behavior. The energy sector’s poor returns over the past decade (consistently some of the worst in global equity markets) reflected not the price of oil but rather the inability of most oil companies to earn a decent return on capital, with expansion given priority over returns. That thinking seems to have changed and capital discipline is holding as the commodity price rises, leading to strong cash flow, increased stock buybacks and higher dividends (Exhibit 2). The commodity price will likely always be volatile, and the industry will still require heavy capital investment, but the focus on shareholder returns is a notable development.
Energy sector earnings are poised to regain share of the U.S. stock market
Exhibit 2: Energy sector weight in the S&P 500, including our forecast
Views from our Global Equity Investors Quarterly, February 2022
Build stronger equity portfolios with J.P. Morgan
Our equity expertise is founded on deep resources across regions and sectors, and a commitment to nurture the brightest talent. Delivering consistent results is at the heart of everything we do.
Outcome-oriented active management:
- Benefit from the local market expertise and deep resources of our globally integrated team of experienced equity investment professionals.
- Gain a broader view on equity markets with our timely macro and market views, and be guided by our proprietary portfolio insights and equity analytic tools.
- Invest across a broad range of actively managed equity strategies, covering multiple investment styles and geographies.
- Partner with one of the world’s leading equity managers and benefit from our long history of innovation and success.