Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
The wonderland of equities
Peter Garnry
Chief Investment Strategist
Summary: Chinese equities bounced back massively with Hang Seng up 9% today as the Vice Premier Liu He said in a speech that the Chinese government intends to support stocks including Chinese ADRs and the economy which is under pressure from higher commodity prices and lockdowns due Covid-19 outbreaks. We go through our views on Chinese equities and whether the recent declines are a buying opportunity. We also go through the different factors that are causing headwinds for global equities despite the recent positive comeback for equities which include rising input costs from commodities and tighter financial conditions.
Liu He speech sparks massive rebound in Chinese equities
Chinese equities have been in a free fall since the recent high on 10 February down 27% as of yesterday’s close as the war in Ukraine has amplified headwinds for the Chinese economy and sentiment on Chinese equities. Institutional investors have recalibrated their exposure to emerging markets due to the war in Ukraine and China’s stance towards Russia during the war has been negative for sentiment among foreign investors. Commodity market volatility and prices have accelerated due to sanctions on Russia which have added more pressure on the Chinese economy which is a heavy commodity importer. Finally, China is battling new covid outbreaks in Hong Kong and on the mainland forcing several regions including Shenzhen into lockdown aggravating headwinds for the economy.
But today the Vice Premier Liu He delivered a speech in which he vowed support for Chinese equities including overseas ADRs listed in the US on top of promises of more support for the economy. Hang Seng gained 9% today closing above yesterday’s close. Talk about supporting equities in many ways are cheap talk and the negotiations with the US over the upcoming auditing requirements for Chinese companies listed in the US could still fail. However, the indicated measures to support the Chinese economy is what really matters for the equity market.
We have many clients that are asking about our view on Chinese equities and specifically Chinese technology stocks. In fact the KraneShares CSI China Internet ETF has been one of the most traded instruments recently suggesting massive attention on Chinese equities among investors. Our stance on Chinese technology stocks has been the same for over a year when the new policies common prosperity started to have an impact regulation and sentiment. We are cautious on Chinese technology stocks as long as they are valued at a discount to US technology companies as a premium in technology is a strong signal on growth outlook and technology. But what about the general Chinese equity market?
Normally, we would use some measure of valuation to operating income such as EV/EBITDA for a comparison on valuation, but for emerging markets it is often better use the dividend yield because this measures real cash outflows from companies diminishing any potential issues around accounting profits. As the chart below shows, Chinese equities are not outright cheap compared to global equities.
Have equities lost their connection to reality?
You always have to be careful when you go against the market consensus because markets are pretty efficient after all. But equities do seem out of touch with reality with European equities down only 2.3% from the close before Russia’s invasion of Ukraine and Brent crude has given up most of its gains since the war started. The only rational explanation for this pricing is that the market is increasingly betting on Russia’s stalling military campaign will lead to a quick peace. That logic has been vindicated today with an official announcement from Kremlin that a neutral Ukraine with their own army is a possible compromise. While this is a positive step things could still change and one would also think that part of any deal is Russia seeking Europe to roll back sanction under some reasonable timespan.
But even if we get peace in Ukraine the sanctions on Russia will maintain for some time and the ripple effects in commodity markets will continue to endure. In addition, the constraints on the supply side of our economy will continue to haunt companies through inflation. Investors need to remind themselves of what the fundamental drivers of equity valuation are:
- Revenue growth
- EBITA margin
- Incremental investments
- Discount rate
Of these four factors only revenue growth is trending positive for equity valuations as the massive fiscal stimulus is creating both inflation and higher nominal growth. However, inflationary pressures, disruptions in the global supply chain, wage pressure, and high commodity volatility are creating headwinds for operating margins which have declined in the previous quarter and no week goes by without more and more companies lowering their outlook for margins; today both BMW and Fevertree were out with a lower operating margin outlook. As the global economy is constrained on the supply side due to a decade of underinvestment and companies are shoring back production in from Asia in a response to the fallout from the pandemic, the incremental investment need will go massively over the coming decade. Yesterday, Intel announced the first plans for its €80bn investment plan over the next 10 years in Europe covering R&D facilities, manufacturing and foundry services. Finally, the discount rate is moving higher with the US 10-year yield hitting almost 2.2% and central banks in an inflation fighting mode suggesting that financial conditions will tighten.
Overall, the vector is negative for equity valuations which still remain at the 87% percentile measured over the period 1995-2022 (see chart). In our view equities will go to its average historical valuation reflecting inflation and the disruption in commodity markets.
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