Asset allocation for a slowing economy
07 September 2021
As investors are bracing for a change in monetary policy and deteriorating economic data, this note aims to illustrate how our portfolios are likely to be impacted in such a scenario.
In our May note, we wrote how growth expectations, measured through the rise in real interest rates, saw a massive upturn following the commercialization of mRNA vaccines. This triggered a rotation from strategies such as the ones we are managing towards broader market ones. Our strategies have recovered nicely since then, with slowing growth expectations building up and "real" interest rates cooling off. The AtonRâ Fund has already outperformed the MSCI World by more than 10% since we published that note.
The macro scenario
A slowing economy may be good news
In the next quarter or two, the Street will likely focus on the tightening of financial conditions by the central banks and notably the FED. We believe this tightening will occur, mainly to restore and strengthen the central banks' credibility. Still, given the worsening economic outlook, it will have to be lighter than what most market participants expect, and as a result, it shouldn't trigger a sell-off in the equity market. However, the Fed has no other choice than act: if it doesn't, it would suggest it perceives the economy as very fragile, a bad sign for the market.
As written in our mid-year outlook, the economy's fragility and supply chain disruptions advocate for "bullish tapering". Nevertheless, a policy mistake (e.g., Trichet in 2011 or Powell in 2018) could be devastating for a fragile economy and the stock market. Considering how the expiry of governments' Covid checks this month is already a form of tightening, the margin for error is narrowing, and some volatility in the market would not be surprising.
Central banks will typically start by reducing their asset purchases (tapering), then raise short-term interest rates and finally sell back the assets purchased (quantitative tightening). This mechanism could take years, and interest rates would eventually be higher without any exogenous adverse market event during such a tightening cycle. Albeit the relationship between higher interest rates and lower equity prices seems reasonable from a valuation perspective, it does not hold over a medium-term horizon, as explained in the following section.
Yields vs. Equity Returns
Empirically, there is no link between yields changes and equity returns. While there could be episodes of a strong inverse correlation (e.g., yields go up, stocks go down), these are not meaningful over a longer time frame. Logically, from a DCF-type valuation perspective, higher interest rates entail lower equity prices as the value of discounted cash flow is lower. However, it is also true that, over the medium term, with positive (negative) changes in growth expectations, both yields and equities drift higher (lower).
But equities are negatively affected by a rapid and unexpected increase in yields rather than a trend move, the latter usually being well anticipated by the market. Comparing changes in the U.S. 10y yields to Nasdaq100 returns on a daily and weekly time frame shows no correlation.
A tightening in financial conditions is commonly considered adverse for equities, and Fed tapering looks likely to be the next tightening event. However, during the previous tightening event following the 2008-09 financial crisis, the equity market did not sell off significantly. And given declining growth expectations this time around, we believe this cycle to be more dovish than the previous one.
Under Janet Yellen as Fed chair, the tightening of financial conditions happened first through tapering in early January 2014. This was followed by action on the Federal Fund Rate (from 0% to 2,25% for a total of nine 25bps increases) starting in December 2015 and via the quantitative tightening that began in late 2017. This tightening cycle did not impact the stock market meaningfully, as the forward guidance was clear, and the interest rate trend was predictable. The table below shows various forward returns of the Nasdaq 100 starting at several key dates.
Impact on our themes
As already performed in our May note, we herewith provide an update on our strategies, focusing on the macro scenario outlined so far and its impact on our portfolios going forward.
Our strategies tend to react positively to a decline in growth expectations during business cycle expansion. As investors search for returns in a low-yield, low-growth environment, they are likely to overweight sectors able to deliver above trend growth and reshaping the world.
Besides, some of our strategies and related sectors are not directly affected by a slowdown in economic growth. For example, having and curing a disease is not tied to any economic cycle. As such, the revenues of medical devices companies are not directly related to economic slowdowns. Moreover, with the need for booster shots that outweighs financial considerations, CDMOs are immune to macro factors in the current situation. Therefore the healthcare sector (through our Bionics and Biotech 360° strategies) offers good defensive qualities during an economic growth deceleration phase.
Similarly, the need for cybersecurity, the highest weight in our Security & Space strategy, is so strong that macro considerations will not disturb it. Even in a durable Covid reemergence and further lockdowns, a possible decrease in demand for surveillance (e.g., smart home security, airports, etc.) is likely to be compensated by an increased need for critical events management.
About our Sustainable Future strategy, a decrease in consumer sentiment could negatively impact demand for end products such as Electric Vehicles. However, the structural growth in renewable energy driven by the energy transition needs is relatively independent of GDP. The sector may attract any new stimulus money that would come to counter the economic slowdown. Moreover, the global softening of the economy may help reduce the price of commodities and ease margin pressures on cleantech manufacturers.
For AI, the main driver remains the quest for better efficiency – an economic slowdown would exacerbate this trend, as companies will need to preserve their margins by increasing efficiency, and AI remains the low-hanging fruit. Also, for Robotics, where the main driver is the aging population and replacing human workers, the search for efficiency will continue to provide sustainable above-trend growth. Finally, a limited slowdown would likely be positive for our semiconductor-related exposure, as it could ease the supply-chain-related chip shortage while inviting investment delays.
On the negative side, our Mobile Payments strategy would suffer from a slowdown in consumer sentiment and spending. At the same time, our Fintech strategy would be a substantial beneficiary of the squeeze on incumbent financial players. Leaner cost structure, technological leadership, and innovation would help challengers accelerate their market share grab.
To conclude, we deem it noteworthy to provide a quick summary of our thematic portfolios' financial metrics to understand their profiles better. The quality of companies making up our portfolios is exceptionally high. Looking at the leverage ratios and the indicator of bankruptcy (Altman's Z-Score), we observe that all our portfolios exhibit a solid ability to service debt, show overall low debt levels, and are at a minimum close to no risk of default. Also, companies that enter our portfolios are carefully considered based on numerous efficiency, profitability, and growth metrics. This transpires through a solid ability to generate robust free cash flows and high return on employed capital while delivering strong growth, especially compared with the broader market.
We continue to believe that any equity investment should include a growth component, especially in a low rates / low growth environment. While the definition of growth stocks varies a lot between investors, we are inclined to invest in stocks whose forward revenues outperform trend growth because their businesses target areas of above-trend expansion. However, these companies should not burn too much cash to achieve these growth numbers. In other words, we favor quality growth.
Investors should also realize that the stellar performance of our thematic strategies and similar market segments last year was made possible by the super-rapid digital transformation induced by the pandemic, which brought forward years of revenues in just a few months. As outlined in our 2020 year-end outlook, we cannot expect such companies to generate similar revenue and earnings growth every year. Still, we are confident in their ability to generate growth above-trend and thus outperform the broader market. We have been advocating for many years and still believe that solid fundamentals and superior earnings growth are the only and most essential variables investors should consider when investing in equities.
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