Mid Cap Stocks occupy a unique place in the market capitalisation continuum around the $2bn to $10bn space. At this stage in the economic cycle professional investors are turning to Mid Cap stocks to solve two main issues.
Many Investment Managers today forecast that India will have the largest Real GDP growth globally in both 2022 and 2023 (~7% and ~6% seems to be the consensus, respectively). However, there are concerns that despite strong company fundamentals, valuations are high and it may be time to go neutral or underweight the Indian stock market.
Such a tactical decision does not diminish the long term structural attractiveness of Indian Equities. The economy remains one fifth the size of China and is starting to be recognised as the China + 1 play. The demographics are a story in themselves with so much potential, given the economy's stage of development.
India represents a market with enormous opportunities. And the global institutional world is starting to wake up to these possibilities. We think this may explain why professional investor traffic flowing inside RFPnetworks to India Equity research is spiking.
In what is turning out to be a challenging year for global stock market returns, the performance of India stands out within the emerging market asset class and global stock markets. In the nine months through the end of September, MSCI India has fallen by 9.7%, compared to the Emerging Markets index that is down 27.2%. Within Asia, only Indonesia and Thailand have performed better than India this year. This builds on a base of very strong long term returns, with India having outpaced the EM index over most time frames. The result has been that the weighting of India within the MSCI Emerging Markets index has increased further, reaching an all-time high of 15.3% by the end of the third quarter. As a result, India’s weighting has eclipsed both Taiwan and Korea, becoming second only in size now to China.
Deglobalisation is here and is not going away soon. It represents a powerful reaction on geo-political realities, climate-related imperatives, and global macroeconomic regime change. But it is not just shaking up corporate broad rooms and forcing the C-suite to rethink strategy. It is also forcing investors to adjust their models for lower stock value expectations.
Investors' focus today is finding investment managers that are able to identify the corporate winners and losers from deglobalisation. But that requires managers with a deep understanding of how the corporate world will look in 2030 and beyond.
Deglobalisation has many interrelated dynamics that will affect stock valuations:
- Western governments are introducing incentives, regulation and new demand that encourages firms to embrace domestic production (e.g. The Inflation Reduction act, the Chips Act, and increased defence spending in the US).
- With the end of the four decade trend towards free money, CFO's are now faced with a higher and rising cost of capital. This will heighten capital allocation decision vigilance and ROI hurdles.
- As reshoring takes hold, margins may come under pressure, driven by higher domestic wage and input costs.
- At one extreme, domestic manufacturing may see a renaissance. And at the other extreme, new tech start-ups may need to deliver profitability before securing funding.
- East-West trade agreements may come under pressure as governments compensate for a deglobalised demand curve for their products, which in turn could alter both import tariffs and domestic subsidies.
It will take time before the new deglobalised equilibrium has been found. For now, investors are mapping out the possibilities, how to manage the risks, and how to maximise returns under a deglobalised configuration.
Part II of the series shows that deglobalization implies a regime change, with trend increases in capex and the labor share, as well as a higher cost of capital, lower potential growth and greater government involvement in the economy. This constitutes a secular headwind for margins and free cash flow (FCF), especially for tech and manufacturing • We are not returning to the low inflation, zero real interest rate 2010s. Further, with the end of the “Great Moderation,” we expect higher macro volatility (of GDP, inflation, interest rates and FX). • With companies facing a higher weighted average cost of capital (WACC), we expect lower average multiples. This will prove especially challenging for longer duration assets, such as venture capital and speculative tech companies that are years away from generating FCF on a sustainable basis.
Whilst necessarily surprising, the Bank of Japan's unexpected decision to raise it's Yield Curve Control (YCC) ceiling is also sufficiently important. In fact, so important that investment managers globally are getting excited about the prospect of a new dawn for Japanese equities and bonds.
As earnings season uncovers the creaks at U.S. large cap stocks, investors are now spending more time researching U.S. small cap investment managers. Given a back drop of rising rates and recessionary pressures, it seems like a contrarian view. But the investment managers they are looking at are doing things differently. Here are 4 examples of the types of U.S. Small Cap companies these managers like:
4 Types of U.S. Small Caps for Recessions
1. Small Cap companies that have managed to keep their balance sheets strong. In doing so, they have protected themselves from rising rates.
2. Small Caps that are not affected by a strong dollar that could hurt non-domestic demand for their goods and services.
3. Small Cap companies that are not affected by supply chain dislocations, or reliant upon maintaining large inventories.
4. And if you can find them, small cap companies which have pricing power with their customers. Which is what the fundamental based research asset managers are doing.
The attraction to U.S. Small Caps today is supported by valuation. Comparing Small to Large Caps, various multiples suggest the market is trading at lows not seen in almost 50 years.
Dividend investing strategies are starting to regain their investor appeal in the current economic environment. Particularly amongst Private Banking clients. Here are the key reasons why:
- Global equity market performance is down around 25% year-to-date (as of 30 Sep 2022).
- 2023 Global economic growth is expected to drop to ~4%, which is one third less than 2021.
- Interest rates are rising across the globe in response to double digit and continuously rising inflation.
This data does not look supportive for traditional Growth Investing strategies. The popular fast growing growth stocks of the bull market relied on cheap easy money and strong macroeconomics. Both of which are currently out of stock globally.
Whilst value investing strategies have staged a strong comeback, the are fundamental differences with dividend investing strategies. These core differences suggest that the outlook for dividend stocks in the current volatile environment is where new money into the equity market may flow.
Growth strategies have long overshadowed dividend strategies. However, changing macroeconomic conditions have turned the tables and dividend investments are enjoying their time in the sun. While this coincides with value’s long-awaited comeback, value and dividend stocks have distinctive characteristics. We believe that dividends deserve to stay in a portfolio even when economic conditions improve. By adopting a fundamental approach to identify companies that can consistently pay and grow their dividends, investors could achieve long-term real return generation throughout the investment cycle.
U.S. Growth Stocks have fallen back to earth this year, and even more so then the broader index. The combination of accelerating inflation and interest rate hikes has switched investors risk-on trade firmly off.
Investing in companies run by new, unproven, or inexperienced leadership teams, building businesses built on disruption and the promise of abnormally high future earnings streams has lost followers. The question today is who are they now following?
Plastic Soup. Climate Change. Water Shortages, Food Shortages...For many these are important, but they are tomorrow's issues, not today's. Yet what these many fail to realise is that they are also today's biggest investment opportunities. Do these three things:
1. Look at the stats on global consumption/resource utilisation, population growth, sources of greenhouse gas emissions, waste and plastic recycling, water loss and demand...
2. Look at how government views on taxing externalities has changed over the past 20 years, and extrapolate forward.
3. Take a look at some of the companies at the cutting edge of food, energy and recycling solutions, then talk to some early investors and strategic allocators to the circular economy.
Within 30 minutes, what you thought were tomorrow's issues, may become today's portfolio priorities.
Diversification has been tough of late with bonds and equities exhibiting co-integration. So the search is on for asset classes that can solve this problem. The research being performed inside RFPnetworks is not necessarily about mean-variance optimisation. It's focused on qualitative causality. Why is one asset class uncorrelated with the current portfolio basket. These insights are pulling investors towards the Chinese Equity onshore market as an underappreciated diversifier.
Recessions put the Corporate C-Suite to the test. When the world is growing, rates are low and inflation under control, steering the Cruise Ship into sunny harbours is easy. But when a macroeconomic tempest takes hold, and your port of call becomes innaccessable, calmer waters and a new destination has to be found. So what is the smart C-Suite doing?
Capital Expenditure is the fuel that powers future earnings. Directing that investment into the themes that will determine the company's success over the next decade is where the thought capital is now being deployed. Two mega themes that touch almost every company globally are Deglobalisation and the Energy Transition. But which leadership teams are embracing change and and investing for tomorrow today? And who are being recognised as the best CEO's of Listed Companies?
One way to outperform an index is not to underperform the index? This is a sine qua non, but in no way useful. Or is it?
Manager Selectors are notorious for looking at performance. But are they looking at the right performance? And what it the right performance? An Information Ratio? A Sharpe Ratio? 3 years? 5 years? 10 years?
This question is of fundamental interest today. With the VIX breaking 30, the S&P 500 hitting it's lowest close since Nov 2021, and year to date global equity indices glowing red, the characteristics of investment manager's performance track records is getting more attention.
And in particular, the usefulness of adding products to their multi-manager portfolios that exhibit up and down market capture in proportions that are different to their existing manager line up.
Long before ESG criteria and ratings became mainstream, many institutional investors maintained exclusions lists. And in some jurisdictions this was written into law. As an example, investments in companies associate with the manufacture of cluster weapons were forbidden in The Netherlands. But what will exclusion lists look like going forward?
In a world where national and regional security has been elevated up to the highest levels on the political agenda, the ESG properties of Aerospace and Defence companies has become a controversial debate. Ideology may be changing along with the new world order. But it is a debate that is surrounded by subjectivity. And finding common ground may be impossible, unacceptable, or even unethical.
The trend towards globalisation follows classic microeconomic theory. Firms wish to maximise revenues and minimise costs and create an inelastic demand curve for a product for which they are the sole supplier. And whilst many firms have not reached this optimal existence, the journey there has embraced globalisation.
But 3 things have changed...
Raising assets for Japanese Equities over the past decades has required patience and persistence.Most institutional investors simply follow but do not over-commit to the market. That may be changing. Across the Japanese Equity manager research, four tangible justifications for serious reconsideration are being hammered home: Relative Equity Valuations, Yen Outlook, Inflationary Outlook, and measurable improvements in Corporate Governance and shareholder returns - as supported the recent increase in share buybacks. Japanese Equity research is currently being eagerly read.
Quite simply...yes. And with reason.
The BOJ’s resistance to tighter policy and higher JGB yields is understandable, but this is not a sustainable situation. Within equities, the impact of a weak yen varies from sector to sector. The BOJ is facing two bad choices: continue to allow the yen to weaken, sapping purchasing power; or, raise rates, likely leading to a drag on economic activity.
China is rarely off the radar of Institutional Investors, but more recently for reasons that dissuaded new allocations: The regulatory crack-down on tech companies; a zero-covid policy that led to entire cities being shutdown, stiffling growth and supply chain fluidity; and volatile geopolitical tensions in the region. But there seems to be a renewed spark in interest as can be seen in the MSCI China Index, which increased around 20% between May and July.
Based on clicks and search queries on China, Institutional Investors seem to focused on three things: Firstly, Chinese Government officials sentiment on economic growth; Secondly, how that growth is now being stimulated; And thirdly, how will that growth impact the global economy. Whilst US-China geopolitical risks seem to be on the increase, from an economic perspective, there are signs that Chinese Equity valuations may be on the rise once again.
Or put differently, can you avoid not to take a second look.
China stocks are slumping on news of rising COVID-19 cases in the world’s most populous country but that doesn’t negate their strong rebound in recent months. The MSCI China Index has still risen by more than 20% since early-May, according to Bloomberg, when it hit what now appears to be a trough. That is a remarkable recovery, given that the world’s second largest economy has been challenged this year by COVID-19 flare-ups – including one that led to a lockdown of Shanghai, home to the world’s largest seaport, in the spring – as well as continuing global supply chain constrictions and uncertainty around Beijing’s regulatory crackdown on technology stocks. Only a few months ago, those factors led some Western market-watchers to openly wonder if China had become “uninvestable.” So for those investors who rode out the downturn, the recent uptick in China stocks is surely welcome. The question, however, is whether the recovery is sustainable.
Whether Bond Yields have peaked was a common search query that had nothing to do with bond allocations. The insights that were viewed were from asset managers running long duration equity portfolios i.e. growth strategies.
Given the underperformance of this segment of the market in the first half of the year, and the poor 18 month outlook for growth, institutional investors seem to be assessing whether the market is now at fair value.
Expect an Increased Focus on Capital Allocation, Quality and Sustainable Free Cash Flow
Until recently, we had been in a disinflationary environment since the 1980s, when Volcker helmed the Fed. This secular trend reflected three forces: (1) Correcting the policy mistakes made in the ’60s and ’70s that stoked stagflation, (2) the increasingly globalized nature of trade, investment, and finance from the mid-1980s, and (3) the deflationary impact of tech, which has been especially impactful during the last two decades. While the latter factor remains in place, we believe it is being overwhelmed by the 3Ds — Deglobalization, Demographics and Decarbonization — meaning we have entered a secular reflationary environment.
The remainder of this note briefly explains each of the three Ds and then concludes with a discussion of what all this means for investors.
The Energy Transition from fossil to cleaner 'fuels' is now globally recognised as an imperative. The initial impetus has come from mass recognition on the need to tackle climate change, global warming and health externalities. And very recently, the realisation that energy security cannot be guaranteed by a reliance on Gas and Oil rich countries such as Russia. But investors are now asking whether the investment case still tenable?
Feeding the world has become more challenging. But the issue is not just a result of supply constraints for wheat, corn, barley and sunflower oil, as a result of the Ukraine-Russia situation. The problem lies deeper. And the solution is creating a substantial long term opportunity for investors.
One would assume that farmers globally would simply rotate their crops, or grow more, to fill the gaps and enjoy the elevated prices. But there are two issues...
The stagflationary backdrop for equities is challenging. And investors are starting to feel the pain of negative YTD performance in their portfolios. Whilst the long term credo of 'stick to the plan' has historically been proven as the right thing to do, on this occasion fixed income markets do not have their back. In our investment research feeds last week, the #1 search query was "Defensive Equity Strategies".
A time for dividends to shine
While there are reasons to be both positive and negative about global equity markets, a more cautious case is gathering momentum. Inflation is now 8.5% year-on-year in the US, while GDP expectations are being revised downwards. Most cycles of tightening by the US Federal Reserve end in recession and this may be no different.
This article by Aegon AM's global equity income team explains why a dividend-focused global equity strategy is worth considering in such an uncertain environment.
The continuance of domestic policies to increase, wages, productivity and equity participation, seems to be yielding shoots of success for the Japanese equity market. Which in turn has professional investors reconsidering raising allocations.
Equities with benefits - Japan?
With volatility running high, sentiment swaying and markets dropping, professional investors are debating whether specific countries are now in a bear market.
But what is the official definition of a bear market? Does it signal a recession lies head? And what was the typical length and depth of previous bear markets?
Japanese Equities are often on the back burner of Professional Investors Portfolios. With each new leadership change over-promising and under-delivering on fundamental challenges that cause continual concern. But is that changing? Several datapoints would suggest it is.
The past 12 months have brought a continuous chain of bad news for investors in Chinese equities. The question on professional investors minds today is whether moving money from China and into India makes sense.
With the Russell 2000 trading at it's most attractive discount to the Russell 1000 in more than 20 years, professional investors are considering looking beyond the cyclical characteristics of U.S. smalls caps. Even as rates are on the rise and a recession may lie ahead.
This contrarian tactical view revolves around the contention that fear is preventing most investors adding to Small Caps (as supported by the current extreme levels of the VIX index) and the belief that the spread between large and small caps will follow the historical mean reversion path.
The story around the recent fall in Netflix has been well covered in the media. A first-mover disruptor, delivering high growth that joined a cohort of technology stocks that became the darlings of the COVID era. Only to be tumbled by the reality that growth may have a ceiling.
Whilst many market commentators have been warning about a repeat of the 2000 dot com era for some time now, they miss the real question on professional investors minds.
Have yesterday's Growth Stocks become tomorrow's Value Stocks?
In 1Q22 the Value Factor clearly outperformed other Factor Risks such as momentum, growth, quality and size. But digging deeper into the explanatory variables, tells a tale of dispersion and extremes.
What can investors expect from each factor risk going forward?
Whilst Emerging markets have underperformed the S&P 500 year to date, the difference has only been marginal. Which is not what many investors expected.
In times of crises, risk-off sentiment usually drives investors away from Emerging Markets and towards 'safe-haven' developed markets, government bonds and gold.
On this occasion, many emerging markets have proved resilient against a challenging backdrop, especially given the headwinds coming from the US: A strengthening US dollar, US Yield Curve inversion, soaring 30-year mortgage rates impacting the housing market, and tighter fiscal policy squeezing consumers. And the tensions between the U.S and China, which has not been helped by Xi Jingping's stance on the Russia-Ukraine situation.
So what is driving Emerging Markets resilience, and specifically, which countries are potential beneficiaries of the current market dynamics?
Whilst the U.S. economy has not entered into recession yet, some strategists are arguing that the presence of an inverted yield curve can slowly induce an economic and stock price downturn.
But how will other markets react, and in particular Japanese equities?
Looking at past episodes of an inverted US Yield curve, the answer is not clear. With the impact on several core Japanese sectors - electric appliances, precision instruments, machinery, pharmaceuticals, automobiles & transportation equipment - being highly dependent on whether the Japanese Yen appreciates or depreciates. Which in turn is a function of the interest rate differential between the U.S. and Japan, and how the Bank Of Japan reacts.
High Alpha Strategies
As performance dispersion across stocks, sectors, and countries widens in tandem with volatility, professional investors are revisiting the alpha generating capabilities of portfolio managers that prefer to run concentrated portfolios.
The rationale being that concentrated portfolios allow more flexibility to outperform 'hard to beat' benchmarks. And given the global macro backdrop and resultant alpha opportunities, this could be the right time to relax investment guidelines and put some passive money to work.
But can idiosyncratic risk be diversified away using a limited number of stocks?
Japan's economy and companies are not immune to commodity price inflation caused by the Russia-Ukraine crisis. However, the world's renewed focus on energy autonomy and net zero emissions (NZE) may boost the demand for energy-related and decarbonisation technologies, made in Japan.
What Style Makes More Sense in the Current Environment?
Common wisdom is that Growth stocks outperform in low-inflation, low-interest rate environments. But they can be vulnerable when rates rise and the value of their future earnings potential is reduced. Characteristics that Value stocks can cushion in a rising rate, inflationary environment. But is it that simple?
The simultaneous & joint impact of COVID, the Russia-Ukraine situation, and simmering geopolitical tensions between China and Taiwan has investors worried. Especially investors in Emerging Markets.
But a closer look behind the EM Equity benchmark tells a different story. And for specific countries, the story is one of opportunity. Especially in Asia where inflation is not necessarily as prevalent as in developed markets.
With Growth stocks struggling in the current volatile, rising rate & inflationary market environment, Dividend stocks have quietly started to outperform their racier peers, by a substantial margin.
Looking back to 1Q 2021 a similar rotation occurred, only to be short lived as Growth stocks regained their popularity.
With reporting season well underway, popular Growth Stocks have so far disappointed the market. Factor in challenging prospects for global economic growth in 2022, this latest rotation may continue, and remains a trending topic for investors looking to diversify their income streams.
Three quarters of Web 2.0 companies did not exist on Web 1.0. Who will be the winners and losers of Web 3.0 and why is the Metaverse important?
Domestically focused US small caps are arguably relatively cheap, and create optionality in the event of a new global risk-on rally.
India was one of the best-performing emerging markets in 2021. Yet YTD 2022 the picture has reversed with net foreign capital outflows and significant selling. But is this all about crude & commodities or is the long term structural investment thesis still valid?
The current rising rate, inflationary environment is causing investors to re-think their recent long term overweight to growth stocks. For multiple reasons.
The question is whether the value factor will provide the downside protection needed. And at the same time, outperform the growth style. Or is it time to revisit the low volatility factor?
The answer may depend on which market or region you are looking to gain exposure to.