Transcript:
Welcome back and thank you for joining us for this quarter’s recap and outlook for the global capital markets. Entering the year, the market was near record highs, only to be weighed down by fears of increased inflation, higher interest rates and the prospect of accelerated Fed tightening. Roughly one month in, we had an added worry with Russia’s invasion of Ukraine. This not only produced geopolitical angst but added to supply-chain issues, both with energy and agricultural commodities, and the US and allies reacted by imposing economic sanctions that further roiled the markets.
The net result, negative returns across the board with higher volatility in portions of the equity markets, such as small-caps and emerging-market equities, and during the brunt of the stock market sell-off. Credit and sovereign bonds were hit by persistent inflation and the prospect of rising interest rates, creating negative results that were sharper than we’ve seen in decades. Of course, inflation didn’t just begin in January. It’s been climbing for months, and the markets have been reacting to this well ahead of the Fed’s recent tightening move in March.
In fact, the two-year treasury yield tripled in just three months. Inflation is a global phenomenon and the severity of it depends partly on where you live. For example, while crude oil has been steadily rising over the last two years, natural gas has as well. However, the pain has been especially acute in Europe, only to be accelerated by Russia’s invasion of Ukraine. A combination of persistent inflation and the prospect of higher interest rates has stoked recession fears. On the surface, recessions have always been preceded by inverted yield curve, but not every yield-curve inversion has triggered a recession. But below the surface today, there are other signals that paint a healthier economic picture.
For example, the Institute for Supply Management survey remains in expansionary territory, which is anything above that 50 mark. Additionally, the consumer is in healthy shape, following years of higher savings rates, stock markets and, more recently, wages. Summing it all up, the current backdrop has led us to lower our forecast for economic growth, while raising our forecast for inflation. And with additional central bank tightening, particularly in developed economies, longer-term interest rates are expected to continue rising.
Most stocks turned lower this past quarter with the exception of energy and utilities. Now, this duo is a counterintuitive mix, given that energy is more economically sensitive and prone to volatility, while utilities are more defensive. This magnitude of outperformance for energy is not likely to be sustained, while utilities may be signaling a slower pace for the economy. We’re seeing some signs for this as ISM New Orders have trailed meaningfully from their recent peak levels. And in turn, the number of companies revising their earnings estimates higher has also declined. In such environments, an exposure to high-quality stocks will likely prove rewarding. When the economy slows, active investors can find quality businesses among both growth and value stocks that have favorable attributes such as high profits, strong free cash flow, positive earnings revisions and pricing power.
Among the growth areas where quality opportunities can be found are companies on the cutting edge of innovation and those aligned with sustainable themes. For example, in the healthcare sector, there are many interesting opportunities. One in particular is in the area of robotic surgery. Such procedures have grown 16% on average over the last eight years. And with the potential of COVID moving hopefully from epidemic to endemic, the prospect for growth here remains robust, given that many of these procedures were deferred over the last two years.
In the thematic realm, the production rate for electric vehicles is expected to grow 25% per year over the next decade. An area focused to capitalize on this trend is within the automotive semiconductors, especially when one considers that the amount of semiconductors that are contained in electric vehicles are twice as much of those used in conventional vehicles. Within value stocks, two industries within the consumer sector stand out. The first is accessories and luxury goods. The other is auto parts and equipment. We believe these exhibit a disconnect between price and fundamentals. Both areas have sold off this past quarter, but each one’s earnings prospects remain solid for the year ahead.
Turning to fixed income, the meaningful change in the rate landscape has had an outsized impact on the bond market versus stocks. This has provided an opportunity for investors not only seeking higher yields, but also improved prospects for favorable returns. For example, the starting yield to worse level has been a good barometer for five-year forward returns under many circumstances. This includes the telecom bubble in 2002 and the global financial crisis in 2008. Our view is bolstered by the fact that corporate profits remain strong and default rates are very low, lower than they’ve been in 15 years. Other areas of credit beyond US high yield have seen their yields rise recently off their lows, but volatility has also increased, especially within areas of emerging-market debt. Particular areas that have a favorable risk reward potential, in our view, are securitized assets and select investment-grade corporate bonds. But above all else, our timeless principles remain of bedrock importance: be global, be selective and be active. Thanks again and we’ll see you next quarter.
Capital Markets Outlook: 2Q:2022
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