We look between investors’ pessimism and corporate CEOs’ sanguinity
Chief Investment Office 1 Apr 2022
- Focus will be on Fed rate hikes concerns being priced in and impact of Russia-Ukraine crisis
- We look to corporate fundamentals again, as opposed to policies and geopolitics
- US Energy sector set to gain given rising energy prices, as a result of the Russia-Ukraine conflict
- Stay the course with US Tech; the selldown will bottom as investors price in Fed rate hikes
- Earnings forecast for the sector remains upbeat with consensus expecting 19% earnings growth in 2022
Major disconnect emerging between equity prices and earnings forecasts. US equities started 2022 on a weak footing as concerns over Federal Reserve policy tightening drove “long duration” equities (like select Technology plays) and rates sensitive equities (like Real Estate) lower. On the flipside, the Russia-Ukraine conflict and surging energy prices propelled US Energy sharply higher as the sector is perceived as both “value” and “dividend” play.
With the acute market correction this year, a significant disconnect between equity prices and corporate earnings estimates is emerging. While the S&P 500 is down 8.0%, forward earnings estimates have been revised up by 6.5%. This suggests two things: (1) Global investors are overly pessimistic, or (2) Analysts and corporate CEOs are overly sanguine. We believe that the answer lies somewhere in between.
As we head into 2Q22, we believe that the headwinds weighing on market sentiment during the first quarter will falter and instead, the following narratives will increasingly transpire: (a) Fed rate hiking concerns are mostly priced in and (b) the Russia-Ukraine conflict has little impact on the global economy. If our view is right, then the focus will switch to corporate fundamentals again (as opposed to policies and geopolitics).
A clear winner in such an environment is the US Energy sector given that rising energy prices will boost the profitability of US oil majors and enable these companies to pay higher dividends or conduct shares buyback. Shell, for instance, has announced shares buyback of USD8.5b in the first half of this year after reporting robust earnings.
On the flipside, surging food prices will be negative for US Consumer Staples companies that fail to pass on the rising input cost. Since June 2020, the UN Food and Agriculture World Food Price Index has surged 48.8% and historical data show that food prices possess a broad inverse relationship with the operating margins of consumer staples companies. Case in point: Between May 2003 and November 2012, food prices increased 126% and it resulted in a 3.2 %pts operating margin contraction for the Consumer Staples sector.
2Q22 US Sector Strategy: Stay the course
Our long-term conviction call on Technology-related plays did not pan out as anticipated in 1Q22 as the rise in bond yields triggered the switch away from sectors perceived as “long duration”. But as investors increasingly “price in” the trajectory of Fed rate hiking, we believe that the selldown in Technology will bottom during 2Q. Our optimism is two-fold:
1. The Technology space operates in a digital borderless world and unlike “traditional” sectors, it is less impacted by rising energy and commodity prices.
2. Earnings forecast for the sector remains upbeat with consensus expecting 19% earnings growth this year and this underlines the sector’s resilience.
The huge run-up in energy prices, meanwhile, could take a breather by 2Q and henceforth, the Energy sector is maintained at Neutral as most of the upside has likely been priced in.