Macro: Sandcastle economics
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Equities are still expensive after rollercoaster May
Peter Garnry
Chief Investment Strategist
Summary: In today's equity update we look back at May which was a rollercoaster ride with first a sharp drop before rebounding taking the MSCI World to a flat performance for the month. As a result, equity valuations are still expensive given the financial conditions backdrop and we remain defensive on equities. Across our theme baskets the best performing were China's little giants, semiconductors, and energy storage. We also cover Salesforce earnings last night and preview MongoDB earnings later today.
The light is still dim for equities
Global equities measured by the MSCI World Index Total Return USD were flat in May following a 5.5% drop during the month as sentiment shifted last week followed up on Friday with signs that inflationary pressures might have peaked. However, Fed Governor Christopher Waller started this week with comments that he is willing to aggressively fight inflation by going 50 basis points at each meeting until he sees signs of inflation cooling. On top of that, ECB’s Holzmann is saying today that Europe’s record core inflation increases the need for a 50 basis point rate hike in Europe. In addition the energy and food situation is still getting worse adding to worries that inflation will persist.
Nothing has really changed and our view remains negative on equities due to our expectation of tighter financial conditions, higher interest rates, persistent inflation driven by a worsening energy and food crisis, and China potentially during more lockdowns this year due to low vaccination rate and its zero-Covid policy. Our valuation model on MSCI World is based on seven different valuation metrics measuring different things from revenue, earnings, cash flows and dividends, and it is still showing that global equities are a half standard deviation above the average valuation since 1995. In our view, global equities should be priced around the average given the current conditions and the trajectory for financial conditions.
In terms of our theme basket we saw a large divergence in performance in May with the best performing baskets being China’s little giants, semiconductors, and energy storage driven by direct Chinese policy actions to revive growth and a continued inflow into energy storage critical for the green transformation. The worst performing theme baskets were bubble stocks, cyber security (one of our favourite long-term themes), and crypto & blockchain as the valuation compression continued in highly valued technology stocks.
Salesforce price reaction shows current reward function
Investors were excited last night over Salesforce’s earnings release which developed a small cut to its revenue outlook for the current fiscal year, but also a small increase in its earnings outlook. Shares were higher in extended trading underscoring the significant change in reward function for companies that has taken place over the past six months. Companies are no longer rewarded for breath neck revenue growth at all costs but instead cost discipline, higher ROIC and margin preservation.
As we discuss in today’s podcast, the Salesforce earnings reaction is an interesting lead in to tonight’s earnings from MongoDB. The company has been part of our bubble stocks theme basket for over a year, and with a 12-month forward EV/Sales ratio of 13.1x despite the stock price is down more than 50% from the peak in November last year, the company is vulnerable to disappointment on margin and cash flow generation.
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