Hear from Witan’s managers on what Q3 and beyond could hold in store for markets

Monday, 04 July 2022

Nobody sounds a dinner gong at the bottom

After an “eventful” start to 2022, we asked our managers what they see as the opportunities and challenges in the second half of the year. There were 6 common themes:

  • Energy prices (affecting consumer living standards, corporate margins and inflation)
  • Inflation and the rise in interest rates
  • The risks to economic growth and PE (price/earnings) multiples within equities
  • Geopolitics, this time Russia rather than China
  • The importance of corporate resilience - pricing power, management and adaptability
  • Climate change as a driver of growth opportunities

At the start of the year, there were hopes that post-Covid reopening would resolve disruptions to international trade and usher in more balanced economic growth, as travel and hospitality sectors returned to normal.

These hopes were dashed by the Russian invasion of Ukraine, the shock of which increased risk aversion and exacerbated existing inflationary threats. The fiscal largesse and monetary boost thrown at a wounded global economy in 2021 created text-book conditions for inflation – too much demand chasing insufficient supply.

Interest rate rises can do little to boost the supply of oil and wheat, much less push Russia out of Ukraine but they can reduce demand, albeit at the risk of recession. The second half of the year could see more of a squeeze on economic growth than the first, as energy prices take spending power away from other areas and rising interest bills put the squeeze on borrowers.

The effects are already appearing in financial markets, with previously fashionable high growth sectors coming down to earth, collapses in the price of unprofitable or speculative assets and rising costs for riskier borrowers. A tougher operating environment as the pincer movement of energy costs and interest rates takes effect will put a premium on companies with pricing power (able to pass on cost increases), effective management (able to improve productivity and adapt to changing conditions) and those operating in growing markets (a slowdown is better than a reverse).

Pessimism and lower prices may be a deflating experience to live through but also present opportunities. Dead-headed roses bloom anew. Just as no-one rings a fire alarm at the top of the market, no-one sounds a dinner gong at the bottom.

Below we summarise some of the comments from our managers and their views on Q3 2022 and beyond.

Derek Stuart, Artemis

The main issue we highlighted for the first half of 2022 remains for the second half – inflation. And this has become more acute with the invasion of Ukraine. The biggest risk is a policy response set to tackle short-term inflation which is sufficiently aggressive to tip economies into recession. A lack of optimism in the outcome has already impacted on business and consumer confidence.

However, many share prices now discount such a recession. We note several indicators that highlight current value. Acquisitions of UK companies by private equity and trade buyers have risen. Directors’ purchases of their own shares have risen. And the number of companies buying back their own shares has also risen, reflecting strong balance sheets. A lot of potential negative news has already been discounted.

Rajiv Jain, GQG

We see opportunities in energy and materials where we believe the fundamentals are strong, due to years of underinvestment resulting in low supplies of certain commodities. We have witnessed what we consider to be real discipline in production growth and capital spending, as well as a renewed focus on profitability, from many energy companies in particular. As a result, we are witnessing strong free cash flow and a commitment to return capital to shareholders via dividends. We believe select consumer staples names with strong pricing power are also attractive in inflationary periods.

We continue to be concerned with inflation, which we see as pervasive across a broad range of goods and services and expect to be stickier for longer. We will also continue to evaluate the direct and second order effects from Russia’s invasion of Ukraine, including spikes in commodity prices and their potential impact on global economic activity.

Lucas White, GMO

Climate change has moved faster than most thought possible and is having a dramatic impact on the world. Economics will drive the transition to a clean energy world, and the climate change sector will experience strong secular growth.

Despite strong performance versus peers and benchmark year to date, we believe the strategy is well positioned from a valuation perspective to offer significant upside (on an absolute return basis). Recent global events are likely to have provided further tailwinds for this sector to the extent that the world moves more aggressively to wean itself from its addiction to fossil fuels by transitioning more quickly to clean energy. This transition won’t happen in a vacuum and will require tremendous shifts in areas like battery supplies and metal production whilst increasing the demand for clean energy substitutes, such as biofuels. Concurrently the supply squeeze in broader commodity markets like agriculture will benefit our portfolio. Compared with peers who simply concentrate on clean energy, this highlights the benefits of our diversified portfolio.

At the end of May, the Climate Change Strategy traded at a greater than 25% discount to the broad equity market (13.4x forward earnings for the Climate Change Strategy vs. 18.4x forward earning for the MSCI All Country World Index), despite having significantly better growth prospects. The current discount is larger than the portfolio has traded at on average since inception, highlighting the attractiveness of this portfolio on a forward-looking basis.

Mark Baribeau, Jennison

Persistent higher inflation; possible policy mistakes by the Fed; increased odds of a U.S. recession; slowing earnings environment and the war in Ukraine continue to weigh heavily on markets. We are focused on finding secular growth opportunities that can weather the changing macro environment. Examples of where we currently see opportunities are consumer brands with direct-to-consumer business models. High quality European consumer brands have been strong, and the resiliency of these brands is even more important in uncertain times like today. Enablers of digital commerce continue to see robust results given the continued rapid growth of e-commerce. Prominent cloud-based service providers continue to see strong demand and valuations have compressed to reasonable levels, making them attractive investment options. We also see opportunities for health care companies that were not COVID beneficiaries but could benefit from reopening and demand for various treatments that were delayed because of the pandemic.

Peter Davies, Lansdowne

The coming quarter is likely to remain dominated by energy prices. Should they continue to rise, pressure on consumption and on central bankers to respond to high headline inflation will persist, pressuring the market. Conversely, stabilising or falling prices could create a more promising outlook, as real wage growth returns and headline inflation peaks. Which of these we observe is likely to be driven by geopolitical events, notably the war in Ukraine and the speed of reopening in China.

Longer-term we continue to believe the dominant trends in markets will be the reversal of the major cycles of the last fifteen years. We expect bond yields to rise as inflation remains elevated and politically driven fiscal spending requires monetary tightening. Within equity markets, we expect capital-intensive sectors to see above-average returns given low historic spend on capacity, industry consolidation and low starting valuations. By contrast, we are already witnessing some of the winners of recent years suffering as high valuations attract significant competition, something we expect to persist.

Michael Lindsell, Lindsell Train

Fears around the impact of potentially sustained, higher inflation have now well and truly taken hold in consumers’ minds and represent a key conversation topic with a large number of our portfolio companies. We’ve been encouraged by the strong pricing actions taken across the board so far and continue to monitor the consequent results (and the potential need for further increases) closely.

The coincident rising interest rate environment, combined with a range of geopolitical developments has clearly resulted in some serious market corrections in the first half, and H2 looks set to be no less volatile. Amidst the general cacophony, we remain resolutely focused on supporting and engaging with our existing, long-standing holdings, while being alert to potential new opportunities within our tiny universe as market exuberance continues to moderate.

Andrew Headley, Veritas

The biggest challenge in H2 2022 is likely to be corporate profitability. Companies have benefited from policy actions put in place to address Covid, with low interest rates and reasonable underlying economic growth, together with benign inflation, leading to revenue growth and margin expansion over the past 2 years. It seems very possible that margins now come under pressure, through a combination of rising raw material prices feeding through all supply chains and rising labour costs as employees face a rapid rise in the cost of living, forcing them to look for pay rises. These factors are likely to arise at a time of slowing economic growth, such that few companies will be able to raise prices to offset their rising costs.

The biggest opportunity in H2 2022 will most likely come from opportunistic deployment of capital into companies that miss earnings expectations and consequently suffer large share price declines that more than compensate for the decline in earnings. In addition to this, opportunities in both healthcare and travel related companies should do well, with the former benefiting from steady demand (and in some cases a catch up of demand post Covid) and the latter benefiting from the opening up of travel corridors post Covid.

Mike Trigg, WCM

Companies around the globe are facing a myriad of challenges including supply chain issues, weakening consumer confidence, and tight labour markets, just to name a few. These challenges also represent a massive opportunity for companies that can better navigate this environment than their competitors and come out stronger. The ability to attract and retain top talent is key, as is having a culture of adaptability. It will take multiple quarters for these factors to show up in the numbers, but these softer elements are critical for the long term.

Witan Investment Trust plc is an equity investment. Please note that past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise as a result of currency and market fluctuation and you may not get back the amount originally invested.

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