US inflation is running hot, and the US stock market is cooling down. Despite what some pundits would have us believe; the US remains the most important economy globally. The depth of its financial markets and the dollar’s status as a global reserve currency entrench this. The US holds the lion’s share globally in terms of investable companies. So, when the US sneezes, the world catches a cold. The latest 50bps hike in the Fed Funds rate, whilst expected, has led to market turmoil. Growth stocks (long-duration stocks) continue to fall, and value is having its day in the sun.
As seen below (looking at the US market), value has outstripped growth (and the market), falling only 8.8% this year, instead of the 28.3% drop in growth. Value is shining, or did value have less of a way to fall? Gold shares have held up well this year, gaining 4.8% but trail dramatically over the long term.
Value has now caught up to growth in terms of performance since the start of the COVID pandemic in early 2020 (see graph below). Everything has moved on dramatically different paths to end up at the same place.
Unfortunately, equities could still fall further. Inflation is the name of the game, and fears of persistently higher inflation in the future have weighed heavily on the valuations of long-duration stocks. That said, higher discount rates will also impact value stocks. Is the pain already priced in?
What causes inflation? Inflation is, very simply put, growth in money, credit and income that outstrips growth in the supply of goods and services. Every GDP growth (or contraction) figure reported in headlines is a real figure. That is an increase in the output of goods and services after adjusting for the broad rise in prices (inflation). Nominal growth, on the other hand, is real growth plus inflation. If goods and services grow with the supply of the means of payment – inflation remains muted. To borrow from Bridgewater, “The pass-through of nominal spending to inflation is the mechanical difference between nominal dollars spent and the quantity produced”. Currently, there is more demand (in dollar form) than supply (in goods form). There are various underpins to this. On the supply side, there are supply chain issues (due to COVID-induced Chinese lockdowns and other logistics bottlenecks) and a decline in the supply of energy and agricultural commodities due to the Ukraine/Russia conflict. On the demand side, we have the effect of monetary stimulus and low interest rates due to the Federal Reserve’s response to the pandemic (and the lingering aftereffects of the GFC). These have created the current surge in inflation—the highest since the 1980s. While the increase in Fed Fund’s rate has not been large in nominal terms, from a percentage change point of view, it is the biggest ever. The market is struggling with the swiftness in the change of conditions.
Has the high point in US inflation been reached? The latest US inflation figure (for April 2022) came in lower than the previous month at 8.3% compared to 8.5%. Unfortunately, this was higher than the expected 8.1% figure, causing market declines. The rate is still ahead of the Fed target so tightening will continue. The core inflation rate, which the Fed follows closely (headline CPI less food and energy), came in at 6.2%, lower than the previous 6.5%. Inflation is still high, as seen below.
Looking at the graph below, we can see that energy is the primary driver – any reduction in energy prices will dramatically change the inflation outlook. An abrupt drop in energy prices will lead to a sharp fall in inflation.
Wage growth continues to be strong and could get stronger as the labour participation rate decreases. However, looking through the early COVID period (which created an initial anomalous wage growth spike as lower earners lost jobs quicker), there are signs of moderation. The latest available data for wage growth in the US (for April) has the growth moderating to 3.7% per annum compared to 5.5% over the last 12 months. A continued downtrend would help lessen the pressure on inflation coming from the wage component.
Inventories are low globally. Chinese supply-chain issues persist (although we see signs of change here as the political elite begin to fear the potential fallout with sub-4% GDP growth). Commodity price increases (especially energy prices) drove the initial inflation spike. The cure for high commodity prices is high commodity prices, as higher prices lead to higher profit and more cash for capital expenditure. Financing for new projects is also more readily available. Thus production (supply) increases. In turn, this leads to lower prices as supply overwhelms demand. This happens over roughly decade-long cycles.
Most of the current jump in prices is due to conflict-induced disruption.
What is surprising is that US dollar strength hasn’t reversed high commodity prices. The graph below shows dollar performance compared to commodity price performance. Usually, this is inversely correlated. That has broken down of late.
At some point, the relationship will reassert itself. Either commodity prices decline, or the dollar weakens. Either one would help the stock market as lower commodity prices would mean lower inflation, and a weaker dollar would signal an increase in risk appetite.
What about other “safe haven” or uncorrelated assets? How have they done? The gold price has held up well. Short-term US bonds (using the iShares 1-3 Year Treasury Bond ETF, SHY, as a proxy) have done ok. Long-term bonds (using the Vanguard LT Treasury ETF, VGLT, as a proxy) have dropped dramatically. Bitcoin has fallen off a cliff since April.
Looking at equities, is high inflation necessarily bad for stocks? If not, is it bad perhaps for growth stocks and importantly, are the stocks held by the underlying managers of the Iza Global Equity Fund only growth stocks?
The below tables show asset returns under two regimes – one where nominal growth is higher than nominal yields (as it is currently) and one where the opposite holds.
As you can see above, the current situation has in the past yielded strong returns from equities – superior to the return of bonds or commodities. Whilst one can look to history as a guide; indeed, past performance doesn’t guarantee future results. So let us look at other information.
The graph above shows the wealth of the bottom 60% of income earners in the US. Those most likely to spend a higher portion of their income on goods and services. For ten years (2005 to 2015), thisgroup’s wealth stagnated. Since then, it has almost doubled. Unemployment has fallen to 3.6%, nearly at the pre-pandemic level of 3.5%. The consuming class is well placed on spending, and companies with pricing power (wide economic moats) should be able to pass on cost increases. This situation seems positive for stocks.
The current financial performance of most S&P 500 stocks is positive. With almost all S&P 500 stocks having reported actual results for Q1 2022, we find that 79% have reported EPS above estimates – higher than the five-year average of 77%. In aggregate, company reported earnings are 4.9% above estimates.
This growth has been across the board, with only the Financials and Consumer Discretionary sectors having earnings declines.
The outlook for the entire year is for 10.1% earnings growth leading to a 12-month forward P/E ratio of 17.6x. This is below the five-year average of 18.6x but above the ten-year average of 16.9x. So, we have strong earnings (but fears of a future slowdown) and multiples lower than the past five years but higher than the last ten years. Where does that leave stocks?
According to Morningstar, this selloff has created value across all sectors, especially in the small capitalisation and growth sectors, both well represented in the funds underlying the Iza Global Equity Fund. At the start of the year, value stocks were better positioned than growth stocks. Now, this has reversed. The below is as of the 5th of May 2022 (source Morningstar Direct); one represents the sector is at fair value, above one it is more expensive and below cheaper than fair value.
We can see from the above that these managers hold a varied basket of stocks in their top 10, with little overlap. 60% of the top 10 holdings have a wide economic moat (meaning they have a competitive edge, pricing power, and solid corporate fundamentals). The quality metrics all stand out, with a high return on assets (ROA), high return on equity (ROE) and lower levels of debt to equity (DE). American Tower Corporation is the outlier, but it is a specialised property REIT. The companies held are not all tech growth stocks, nor are they cash flow negative or loss-making fledging companies. The underlying funds have a definite bias to quality stocks and have a varied sector breakdown.
The bulk of the underlying companies operate in the Information Technology sector, but there is a good split of sectors.
The underlying fund that has performed the worst year to date is Scottish Mortgage Investment Trust (SMT) which has lost over 40% of its value.
SMT has exhibited exceptional growth over the last five years, more than doubling. SMT has about 24.7% of its portfolio in non-listed private companies and the market appears to be worried about this portion of the Trust, on top of the market movements of the listed holdings. In our correspondence with SMT, we have learned that aggregate private company performance has been broadly flat over the last six months. They have also been prudent in writing down assets. Bytedance has been written down despite performing well operationally and taking market share. In Meta’s last earnings call, the CEO Mark Zuckerberg mentioned Bytedance as the reason for Meta’s weaker results. Bytedance was written down due to the reduction in the multiples of listed peers.
The managers of SMT feel there have been a wide dislocation between share price and operational performance. The valuation of the unlisted companies in the SMT portfolio is done on a rolling basis (one-third of unlisted holdings are valued each month) by an independent valuation committee within Ballie Gifford independent, who takes third-party advice. The fund managers have no input. SMT have told us that they continued to rigorously analyse their holdings and meet with companies to assess fundamentals over the last year. They have completed this exercise and are “enthused” by the operational performance of their underlying holdings. They see no significant operational disappointments in the top 30 companies they hold.
The average 3-yr sales growth forecast for the listed equities portion of the portfolio stands at 20% compared to the FTSE All-World, which has an average 3-yr sales growth forecast number of 8%. SMT has shifted the portfolio to owning more companies that are growing revenues faster, as evidenced by the below graph (source SMT).
The area where the stocks held in the Iza Global Equity Fund may differ from the mean, is on their valuations. 12-month trailing price-earnings (PE) and 12-month forward price-earnings (Fwd PE) for the underlying funds could be considered high. Below we compare the metrics of the top 10 holdings of Fundsmith with the top 10 holdings of a representative US Value ETF (the Vanguard Value ETF) and a representative Energy ETF (the Xtrackers MSCI World Energy ETF).
We can see from the above that the longer-term performance of the shares held by Fundsmith (who have held 12 of their 29 shares since inception) has outstripped the other options. However, over the last year, and year to date, the Value and Energy ETFs have outperformed, driven by energy stocks. The quality metrics (ROE, ROA) of the Fundsmith holdings are superior to those of the other two. However, most stocks held by the other two funds trade on far cheaper PE multiples. Does this mean that Fundsmith holdings are overvalued? And are the value holdings therefore undervalued? It is not that simple.
The following borrows from Professor Damodaran, who teaches corporate finance and equity valuation at the Stern School of Business at New York University. A fair price earnings multiple can be derived from a firms payout ratio (the percentage of earnings paid out as dividends), assumed growth (which is a function of a firms return on equity and retained earnings, over the long term) and the required rate of return (a function of the risk free rate, normally the US 10 year bond yield, the firms beta to the market, it’s perceived riskiness, and the equity risk premium). The equation is:
In the above the payout ratio over the longer term can be determined using the following:
The above would be for a stable mature firm, that is growing at a constant rate into the future. Getting slightly more complicated, we can use the below equation to generate a fair PE multiple using two phases of growth. A higher near- term growth period and the mature period after that. This will get you to the following equation:
This looks complex, but the ideas are simple. The more a firm generates in returns (ROE), the higher its potential growth and PE. The more cash a firm pays out (higher payout ratio), the higher a firm’s PE. Finally, the riskier a firm is (higher discount or required rate of return), the lower its PE will be.
Using the above equations, taking current firm ROEs and payout ratios, using a US 10-year bond yield of 5.5% (in line with the long term average and far ahead of the current rate), making some assumptions around the long term figures, and using a market beta for Microsoft that is far ahead of its actual (1.2x vs 1.0x), to suggest tech is now riskier, we find the following:
Microsoft at these levels is trading below its fair PE multiple; consensus has an implied 22.2% earnings growth for the coming year. Earnings growth, plus reversion to fair PE multiple, means there is currently 33.3% potential upside for Microsoft. Whereas Exxon has 21.1% upside and United Health has 23.2% downside potential. Just because a stock has a higher valuation multiple does not necessarily mean it has less return potential than one with a lower multiple.
For those of you who have made it this far well done! The picture painted above is an attempt at showing you that things aren’t simply a cut and dry case of rates going up, leading to growth and tech stock valuations falling to nothing. Yes, higher US inflation (leading to a higher Fed Funds rate), and the start of quantitative tightening will lead to higher 10-year US bond yields and higher discount rates for equity valuations. This isn’t good for all equities, not just growth stocks. But the market turmoil caused by the current rout in growth stocks has led to market panic and some illogical moves in share prices.
What should be remembered is that the managers of the underlying funds aren’t simply sitting doing nothing. Such periods of market turmoil allow managers to strengthen their portfolios by adding stocks where the risk/reward dynamic was previously not to their liking. The current situation will give rise to attractive entry points for many shares. Fundsmith has built a position in Adobe on the back of the current turmoil. Managers will be working hard to position their portfolios in the best possible manner for the subsequent recovery, and there will be a recovery. Whilst we cannot say if the recovery will be in the next three months or over the next year, there will be a recovery. The below table shows the level of changes in various US indices:
When we have such large movements in such a short space, the rebound usually is equally as sharp.
The below graph shows that the forward PE of the S&P 500 Index is now slightly cheap. Another 10% down would be a very good time to buy.
The current and year-end projections for US rates would not make them high by historical standards. A Fed rate of 3% for inflation that settles at 2% long term is not punitive. The valuation exercise done above used a 5.5% level. That would imply inflation of around 4%. Even at this higher level, we still derive potential upside in Microsoft. Quality stocks are, by their nature, best placed to perform well through business cycles. Equity managers cannot forecast what price Mr Market will place on a stock at any point in time. They can identify those stocks best placed to perform strongly from an operational perspective, and thus provide the most compelling investment case. Whether the market recognises the value inherent in the stock today or in 3 years is not knowable.
Investing in the stock market for those who cannot stomach volatility is perhaps not the best course. However, this very volatility in the asset class is why equities outstrip other asset classes in terms of long-term growth. The concept of an equity risk premium captures the idea that investors demand extra return for taking on the additional risk of the stock market.
We want to say that the auguries are favourable, and the market will recover completely by the third quarter of this year. This is something we cannot forecast. It is proven that meteorologists have a better track record than market forecasters. We firmly believe that the underlying fund managers of the Iza Global Equity Fund hold a basket of quality companies that have economic moats, allowing them to weather the current inflationary environment. When the market does turn, the portfolios of the underlying managers will be well placed for a sharp recovery.