Global equities have had a challenging start to 2022 amid a perfect storm of bad news: Russia invaded Ukraine, inflation is rising at its fastest clip in decades in most developed economies, and central banks have begun to tighten monetary policy. Equity valuations—which had benefitted from unprecedented liquidity injected into financial markets to blunt the impact of the Covid pandemic—responded in kind.
While many investors are taking a “risk-off” approach, we remain sanguine about the long-term outlook for global equities, especially in non-US markets, including developed Europe and China. Opportunities now are more selective as a function of drying liquidity and rising interest rates, but we see four areas of interest for investors to consider today: equity performance dispersion in certain markets, quality firms with pricing power, bargain hunting amid higher volatility, and digital Darwinism.
Equity performance dispersion favors certain markets
For the first two months of 2022, the MCSI All Country World Index lost 7.4% as expectations rose about how many times key global central banks (i.e., the US Federal Reserve and the European Central Bank) will hike interest rates. In January the consensus was for the Fed to hike three time this year. As of mid-March, expectations were for a total of seven.
The end of an era of loose monetary policy—which bolstered equity valuations in 2019 (MSCI ACWI up 26.6%,) 2020 (16.2%) and 2021 (18.5%) and contained volatility—has sparked a rotation from growth to value stocks for many investors. This rotation, in turn, has generated a widening dispersion of returns, as volatility rose, and allocations were adjusted at the stock, sector, country, region and style-factor levels. For example, within the US, the tech-heavy NASDAQ dropped 12.4% in the first two months of the year, significantly underperforming the Dow Jones Industrial Average, down 6.9%.
That dispersion reflects the sharpest growth-to-value rotation in a decade, as does the strong relative performance of London’s FTSE 100, weighted heavily to value sectors, such as banks, energy and miners. In Europe, by the end of February, the MCSI Europe Value index outperformed the MSCI Europe Growth index by 11.1%.
The performance dispersal is also evident in China’s various stocks markets. The MSCI Overseas China, dominated by mega-caps trading as ADRs, fell 38% in 2021 versus gains of 3.2% for the all-cap MSCI China A Onshore Index, (stocks traded in Shanghai and Shenzhen,) which better reflect the growth potential of the domestic Chinese economy.
The takeaway is that selectivity is paramount. A recent MSCI paper found that high cross-sectional volatility in equity markets offers “greater opportunities for active managers.”
Quality firms with pricing power should outperform amid high inflation
Albeit important in the short run, the debate about whether to rotate from growth stocks to value stocks should be, in our view, of less concern to long-term investors. In other words, what’s most important over the longer term is investing in great companies—ones with the ability to structurally grow long-term cashflows and earnings—irrespective of whether they are considered as growth or value. Investors wondering what qualities make for great companies can review Porter’s Five Forces, a framework for evaluating the competitive strength and long-term potential of a business. Of particular interest now are companies with pricing power that can pass on higher prices to end users while inflation is high. We are already seeing greater differentiation in earnings results between companies that can pass on higher input prices to customers and those left compressing their own profit margins—a topic likely to make plenty of headlines in the coming quarters as earnings reports reflect this new reality.
Volatility creates bargains
In volatile markets, investors need to take the time to separate the signal from the noise. Global stocks have been awash with liquidity thanks to key central banks’ rapidly growing balance sheet. The Fed, for example, has doubled its balance sheet to just under $9 trillion since early 2000. To use a fishing analogy, that liquidity is like dropping dynamite in a lake: fishermen can easily pick any floating fish and likely profit, even with the most speculative firms. Today, as liquidity is withdrawn, the lake still has plenty of fish, but investors must work harder to find good ones. Having said that, it is noteworthy that the recent sell-off has been top-down, dragging down many companies with strong fundamentals that reported very strong 2021 results. That suggests many of these firms are victims of the rising-rates narrative, creating a bottom-up opportunity for bargain hunters.
Digital Darwinism is reshaping the economy
The Covid-19 pandemic has accelerated the trend of digital Darwinism, whereby companies that establish superiority in crucial new technologies can gain a long-term, transformative advantage. Having reimagined the consumer tech world, this trend is now sweeping the business-to-business tech ecosystem. Key industries at the forefront of such change include artificial intelligence, cloud computing, robotics, industrial automation, electric vehicles, renewable energy technology, among others. While consumer-facing US tech behemoths outperformed in recent years, many European companies are now providing the underlying technology, software or hardware to facilitate many of these business-to-business (B2B) thematic trends. Likewise, China is investing heavily in these areas, too, attracting a record $131 billion in venture capital in 2021, according to the research firm Preqin. Given that, investors should diversify and look for opportunities in regions that were largely overlooked in the recent tech boom.
Amid such volatility, investors should get back to basics, seeking out quality companies that can thrive in these challenging times. The opportunity extends beyond the US, Europe and China to such places as South America, the Middle East, Africa, Japan and Australia. As tough as volatile markets are, with the right research and by taking a longer-term view, investors can benefit.
Opinion by Marcus Morris-Eyton, Growth Equity Portfolio Manager based in London, and Christian McCormick, Senior Product Specialist based in New York, both at Allianz Global Investors.
For Funds Society, Madrid