KEJI - October 2023 Active Management Insights: Higher-For-Longer Interest Rates A Chief Concern

2023-10-27 00:52:00 ET

Summary

• The expectation that interest rates will remain at high levels for longer than anticipated is leading equity managers across the globe to favor companies with strong balance sheets. Conversely, managers are more cautious on companies reliant on loans or requiring financing.
• Managers remain divided on China equities, but valuations are attractive relative to history and the broader emerging markets opportunity set. Managers are cautiously re-engaging on China through idiosyncratic bottom-up ideas.
• Anti-obesity GLP-1 drugs have emerged as a significant investment theme this year, propelling the pharma companies developing these products to significant gains year-to-date.
• U.S. companies viewed as on the wrong side of this trend within medical devices and food products have underperformed.
• Some managers believe current valuations among these companies reflect overly pessimistic forecasts, and are beginning to initiate or increase positions.

The third quarter saw an end to the strong run in equity markets, with markets posting their first negative quarter in 12 months on concerns over the longevity of the higher interest rate environment.

Investors now anticipate that most central banks will need to hold rates at higher levels for a longer period of time than previously anticipated, as inflation remains above target levels in most developed economies. This adjustment in rate expectations sparked a renewal in negative sentiment during the third quarter. In addition, oil prices are expected to remain elevated in the wake of OPEC+ countries’ agreement to extend production cuts until the end of 2024, while the ongoing war between Russian and Ukraine and uncertainty in the Middle East following Hamas’ attack on Israel are also continuing to put pressure on inflation and broader investor sentiment.

Amid this uncertain backdrop, we believe that the views of specialist managers are critical to exploiting both risk and opportunity. Drawing on our unique relationship with underlying managers, we’ve compiled the latest insights from specialists across the manager universe into an easy-to-read report. Listed below are the broad overall trends from equity managers heading into the final months of the year, followed by the main tactical observations from key equity and geographic regions across the globe.

Broad global trends

Higher-for-longer interest rates

• This is particularly an issue in developed markets, which has impacted longer duration investments. There are also increasing concerns around companies dependent on discretionary spend, given the knock in consumer confidence.
• Managers continue to favor companies with strong balance sheets and those able to self-fund investments, while being more cautious on those reliant on loans and/or requiring refinancing.

Commodities tailwinds

• Managers globally remain positive on commodities with ongoing allocation.
• This is supported by a combination of structural demand. For example, metals such as copper are critical in the transition to clean energy , whereas cement and iron ore are benefiting from the onshoring of supply chains, which require infrastructure investments.
• At the same time, supply constraints are providing structural support for commodity prices.

Higher energy prices for longer

• Managers continue to favor energy on the back of expected higher-for-longer oil prices. This is supported by the lack of investments in the industry, production cuts from key OPEC+ members (Russia and Saudi Arabia) and growing uncertainty on the back of potential instability in the Middle East as a result of Hamas’ attack on Israel.

China sentiment

• There has been a meaningful reduction in global funds’ China exposure and while managers remain divided, valuations are attractive relative to history and the broader emerging markets opportunity set. Managers are cautiously re-engaging on China through idiosyncratic bottom-up ideas.
• There are also positive green shoots , with fundamentals being rewarded, particularly in the consumer sector. In addition, continued government support for the real estate sector has been well received.

Positive macro and governance reforms in Japan

• Investors have continued to add exposure on the back of positive sentiment driven by reforms, recovery in the economy and changes to consumer behavior.

Highly disruptive drug innovation

• Anti-obesity GLP-1 drugs have emerged as a significant investment theme this year, propelling the pharma companies with GLP-1 drugs to significant gains. Markets have penalized companies seen on the wrong side of this trend within medical devices and food products, which some investors believe has been overdone.

Australian equities

Earnings growth challenged in 2024

• Managers expect that company earnings will be under pressure next year. Higher input costs—both labor and goods—plus higher interest costs while demand declines due to a slowing economy are expected to materially squeeze margins for many companies.
• Many managers are favoring businesses which have structural growth, the ability to maintain margins and strong balance sheets.

Keeping up the energy

• Despite the sector’s outperformance in the quarter, managers continue to hold their overweights in selective energy producers.
• Their reasoning is that the underinvestment in oil and gas capital expenditures over the past 10 years will lead to undersupply. Recent capex is significantly less than when oil was last at current prices. Meanwhile, the demand for oil and gas is expected to remain strong in future.
• Geopolitical instability is likely to further support Australian energy producers.

Canadian equities

Continuing opportunity in energy

• After a strong quarter, equity investors continue to be bullish on energy stocks, but are focused on energy production over infrastructure. Current supply-demand dynamics are favorable, and managers are also considering energy as a risk-hedge to the conflict in the Middle East.

Mixed views across materials sector

• Copper companies are seen as the most attractive segment, with energy transition a key long-term secular driver. Gold-mining stocks are also seen as having compelling fundamentals and helping hedge for inflation, but investors are highly sensitive to the location of assets and potential political risk.

Financials are unattractive

• Managers continue to be wary of the Canadian banking sector. Banks are facing considerable headwinds from slowing loan growth as loan losses trend higher. Also, while banks’ price-to-earnings (P/E) ratios are at the low end of their historical range, their current earnings yields are not attractive compared to bond yields, given the context of higher interest rates.

High dividend yield stocks are likely to languish

• In addition to banks, other companies and industries that offer high dividend income, such as utilities and energy infrastructure, are expected to struggle since bond yields offer compelling income opportunities with lower risk.

Emerging markets equities

Has China bottomed out?

• While managers are divided on China opportunities with macro concerns and uncertain timing around improvements, valuations are attractive versus history and the broad equity opportunity set.
• The Chinese government has increasingly introduced easing measures to support the real estate sector, which was a key pain point of negative sentiment. Value managers in particular have been adding selectively to those with stronger balance sheets that are expected to weather the storm and come out stronger.
• There have been some positive green shoots with fundamentals starting to be rewarded, particularly within consumer discretionary.

Optimism for Latin America continues

• Many economies with high real rates, such as Brazil and Chile, are already on an easing path, which provides a positive backdrop for their economies and equity markets.
• Many of these countries also benefit from a positive commodity cycle, which is largely a common view among investors.
• Although Brazilian equities saw a weak quarter due to potential implications of corporate tax reforms and a re-uptick in inflation, EM (emerging markets) managers remain positive and continue to allocate to opportunities across the broad Brazilian market.

India structurally attractive but expensive

• The long-term structural growth case for India continues to improve with China decoupling, leading companies to increase India capital expenditures and infrastructure spend—both of which are growth drivers for the Indian economy.
• In the short-term, however, there are some concerns about valuations leading to trimming of positions.

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