Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett highlights the four key issues he will be watching going into the second half of the year. Niall Gallagher discusses a strong earnings season for European equities and shares his thoughts on the European banking sector.

07 June 2023

David Dowsett, Global Head of Investments

Moving on from the debt ceiling drama, investors are thinking about the key drivers for the second half of the year. There are four key issues that I think are going to be important as we move into H2 2023.

1. Firstly, and most importantly, is whether the US economy will move into recession in the second half of the year. This has been expected for some time but has not happened yet. The latest data indicates that it may not transpire in H2. The payrolls data published last week was very strong, with more than 300,000 additional hiring, with the services sector in the US seeming extremely resilient. There are some areas of weakness but an unemployment rate of 3.7% in the US does not presage an immediate fast slowdown that will send the world’s largest economy into recession. Throughout the developed world, growth looks more resilient than expected three months ago.
   
   
2. The second issue is the behaviour of central banks. In the short term, the Federal Reserve (Fed) has signalled that it will pause at the June meeting, pending an important CPI number next week. Beyond that, I sense that real interest rates are not high enough to cause the slowdown that central banks want to see in order to address continued stickiness in core inflation. I think we are likely to see continued rate increases after the short term pause from the Fed. As we move into the second half of the year, increases in real interest rates will likely occur from some decline in inflation. Nonetheless, it seems to me that we have not reached the peak and we still need to see more monetary tightening from all developed central banks in the US, Europe and the UK. This could cause some volatility given what is priced into the market.
   
   
3. The third key issue is China. While the US has been more resilient than expected in the first half of the year, China has been less resilient than expected. The latest data shows more of a slowdown. I think China is suffering from an over investment problem, particularly related to the housing sector, and it is proving hard to work that out. As a result, the rebound following the end of zero Covid restrictions has not been as dramatic as expected. I will be looking for any stimulative measures, either monetary or fiscal. There was some indication that the government was going to lessen the restrictions on investment in housing last week, which is the type of event we would watch. However, China is not performing as expected on an economic level or an equity market level, and as a result we have seen negative returns from the equity market in the first half of the year.
   
   However, in emerging markets (EM) ex China, growth is outperforming. Brazil’s Q1 GDP release outperformed expectations last week and India is currently tracking 9% growth. This is an interesting change in that we have expected China to be the key impetus for EM growth for so long. China is tracking around 3.5% GDP growth in the second quarter, while EM ex China is tracking around 5%. I think this is likely to continue and is reflective of the different cycle of growth that China is going through relative to the rest of EM.
   
   
4. The fourth point I would highlight is the effect of the liquidity drain that will be carried out by central banks on markets in H2. The Treasury in the US is going to rebuild its account. It had to run it down close to the debt ceiling but as it rebuilds it, up to a trillion dollars of liquidity could be taken out of the market in the second half of the year. There is a debate about where that liquidity comes from; it could come from banks running down reserves or outflows from money market funds. Nonetheless it will be a net withdrawal of liquidity at the same time as continued quantitative tightening. In Europe, the European Central Bank is running off some of its targeted longer-term refinancing operations (TLTROs). This liquidity drain will be a marked change from the first half of the year when we saw a significant increase in liquidity provision. This could be interesting as in the first half of the year, the US equity market traded in the old fashioned way of more liquidity being devoted to a smaller number of stocks. The S&P is up 11% in the first half of the year, yet the index weighted S&P is down 0.7% for the year. All of the return has been driven by seven stocks: Google, Meta, Nvidia, Amazon, Microsoft, Apple and Tesla. These stocks are up over 70% on average but the average stock everywhere else is down. A change in liquidity dynamic could change that. There is a speculation about the impact of computer driven trading concentrating more returns in a smaller section of the market. If the liquidity signal changes, that could be interesting to monitor.

Niall Gallagher, European Equities

The core trends and many of the thematics we focus on have not changed over the past six months. The US economy is robust, which is something we see clearly through Q1 earnings; European economies are in better shape than had been expected, which is also evident in economic numbers and company numbers. Nominal GDP growth is very strong and this is what drives earnings growth; earnings growth in Europe is strong and has been continually ahead of expectations over the past few quarters.

Furthermore, many structural growth trends remain evident:

• Luxury continues to perform strongly; the US is flattening out having been exceptionally strong over the last few years while Europe remains robust. Despite China being generally weak, luxury consumption has rebounded strongly and there is no evidence of that slowing down as yet.
  
  
• Digitisation and the rapid expansion of semiconductor power remains an important theme as was evident in the recent Nvidia earnings announcement and the explosive growth of AI; a number of European technology and industrial stocks are heavily exposed to semiconductor capex spending at the ‘leading edge’.
  
  
• We are also seeing evidence of decarbonisation and investment for the green transition. The Inflation Reduction Act in the US and what Europe may do has captured imagination. We are beginning to see some very strong growth on the back of companies preparing to invest to take advantage of some of these great subsidies.

What is different versus six months ago?

• The Chinese recovery has been weaker than anticipated.
• Oil and gas prices have been lower than expected. We do not think the structural position has changed; however, the fall in the gas price in Europe has been quite dramatic and that has had positive implications by and large for the continent.
• The acceleration of AI.

Earnings

Looking at the MSCI Europe’s 12-month earnings trends, it is noticeable how strong Q1 earnings were. Over the last year or so, earnings numbers have generally been better than expectations but Q1 was exceptionally strong. On the downside, energy has been impacted by weaker than expected oil and gas prices. The areas of strength include financials, mainly banks which have continued to excel in terms of numbers. Industrials have also performed well; industrials capture a range of different sectors, including some of the long cycle investments into decarbonisation but also some of the shorter cycle areas of industrials, where we have not seen the slowdown which was expected. Consumer discretionary to a degree reflects luxury and affluent consumer spending which has also been better than expected. We think, broadly speaking, the better expectations for the economy have been reflected in the earnings numbers.

Banks

European banks are currently trading at a P/E ratio of below 7x earnings. Over the last 25 to 30 years, the typical P/E for banks was around 10x earnings. A significant decline in earnings is currently priced in. Despite this, the earnings revision trend, which is the ratio of upgrades to downgrades, is very high. It is at a point where you would typically see banks re-rating to higher valuations as the market sees this acceleration in earnings. However, the opposite has happened. The only way to justify these valuations is a belief that we are entering a very severe recession which will lead to loan loss provisions going up, which we do not see, and even if there was a severe recession the banks are so deleveraged you would not have a large decline in asset quality. Alternatively, the market does not accept that the era of zero interest rates is over. We believe the sector will re-rate and there are significant opportunities here. Banks are currently on the lowest P/E relative over a 30-year time series. European financials are now paying dividend yields in the high single digits and there are also significant buybacks. The dividend plus buyback yield is about 15% for some of our bank stocks. If the stocks do not re-rate on an earnings basis, or even a price-to-book basis, the share prices will likely rise in line with buybacks and the dividend still offers returns. We think bank stocks could provide a 15% total return per year for the next three to four years based on dividends and buybacks.

Gas prices

Gas prices were much discussed a year ago as they were set to have a very big impact on both the consumer and corporates in Europe. On the back of the explosion of methane gas prices in Europe, we have seen state intervention in the UK and other countries, such as a cap placed on methane gas prices. The good news is that the gas price has come down much more than expected. We are now back down into the range that pertained for most of the 2010-2021 period. In other words, gas is priced at approximately USD 7/MMBtu which is low. There are a few reasons why gas prices have come down. The first is the mild winter in Europe; for most of Europe, average temperatures were higher than prior years which meant that demand was low. The second is that China has not rebounded; last year when liquified natural gas (LNG) prices were high, China was in a lockdown so it was not importing much but it was also re-exporting some of its inbound LNG and as yet, we have not seen China begin to ramp up gas usage. Finally, we have seen industrial gas demand in Europe fall for a number of large industrial sectors. Capacity was shut in or methane gas replaced with oil or coal. This has not yet switched back. We would expect all three causes to re-emerge as issues. If we have a normal winter, if China demand comes back and if some of the European industrial businesses return to gas, prices will rise again. For now, low prices are a key positive for consumers as gas prices are one of the key utility bills in Europe and gas sets the price of electricity. We should expect this to feed into a broader consumer basket, in particular food prices which are also heavily influenced by gas prices. As a result, we think that headline inflation in Europe, although not necessarily core inflation, is set to come down quite sharply and that is a boost to real consumption and will help the earnings power of the region.