The rapid increase in global inflation has forced central banks to drop their pro-cyclical positioning and adopt a restrictive monetary stance, even as the macroeconomic and geopolitical environments have continued to deteriorate. The monetary tightening has led to large corrections across markets, particularly in long-duration assets such as growth and quality stocks, as higher interest rates have fed through to higher discount rates in valuation models.
In contrast with previous crisis periods, the worsening economic backdrop has not been accompanied by revised earnings growth expectations so far. With major equity markets now trading below or near historic average valuation multiples, we see less risk of a further derating ahead. However, earnings expectations may need to be revised downward to account for slowing global growth, and asset prices should eventually correct in favour of the more defensive and quality segments of the market.
Extending the investment horizon
Analysis of large drawdowns in recent history reveals that taking advantage of attractive entry points is rewarding over the medium to long term. The 5-year or 10-year forward performances recorded following market lows have typically been above average. Looking more specifically at the performance of different investment styles on the US market since 2001, we see that year-on-year inflation of below 1% represents the most favourable market environment for quality and growth investments, while momentum comes under the greatest pressure in periods where inflation is above 5% y/y. Both quality and value show more resilience in periods of high inflation but, over the entire study period, value has clearly underperformed the other investment styles. Equity markets have shown to be driven over the full cycle by fundamentals and the survival of the fittest companies, rather than short-lived style or sector rotations, hence the need to identify companies that deliver attractive real returns over the medium to long term.
Pricing power is key
In periods of inflation, companies’ operating costs usually rise faster and on a greater scale than they can be passed on to customers. It is therefore important to assess the elasticity of demand for products and services in different industries as a gauge of a company’s pricing power. As interest rates are hiked, companies’ cost of capital also rises as interest payments on variable-rate loans increase and refinancing for longer-term fixed-rate debt becomes more expensive. Companies’ value-creation levels – i.e. the spread of their CFROI® (Cash Flow Return on Investment, source: Credit Suisse HOLT) above the cost of capital – could thus come under pressure, especially if that spread is so thin that it is heavily eroded by the higher cost of capital.
Cash flow is king
If a company is successful in passing on higher costs to its customers without losing any sales volume, and without compromising on its production capacity and quality, its cash flows should not be eaten away by inflation and it can offer investors the potential for attractive real returns. From this perspective, a company’s balance-sheet quality and its ability to generate cash flow provide a better indication of its competitiveness and the sustainability of its returns in adverse market environments than comparing multiples based on earnings per share.
Focus on sound fundamentals
According to UBP’s Swiss & Global Equity team, a consistent and disciplined investment process in search of value-creating companies in all market conditions remains the key, and no concessions should be made to accommodate short-term market sentiment. Timing inflation trends and investment style or sector rotations could prove inefficient for medium- to long-term investors because, over a full cycle, equity markets remain driven by fundamentals.
The main source of alpha-generation over the medium to long term for all strategies managed by the team has consistently been stock selection based on the CFROI® framework, rather than sector, regional or style positioning. The current phase of the economic cycle could represent an attractive entry point as investors should return to appreciating predictable and sustainably high levels of value creation if the global economic downturn continues.
Senior Investment Specialist – Swiss & Global Equities
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