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Helen Jewell | Alpha opportunities in an unusual cycle

Helen Jewell | Alpha opportunities in an unusual cycle
24-11-23 / Helen Jewell

Helen Jewell | Alpha opportunities in an unusual cycle

Flat earnings seen over the last quarter could continue into the new year, as investors tussle with the outlook for inflation and growth, keeping equity markets in a holding pattern. We believe the rates set by major central banks may be nearing a peak – a positive for equity markets – but the lagged effects of this potent rate-hiking cycle still present the risk of recessions, as we have seen in Germany this year.

However, this is no typical business cycle. The lagged effect of the Covid-19 pandemic, and the impacts of decarbonisation and deglobalisation mean that an economic recession may not translate into an earnings recession and could explain stock market resilience amid slowing growth.

We believe these forces have created sub-cycles within the business cycle, adding to dispersion within markets and creating opportunities for stock pickers.

Still playing COVID catchup

The stop-start of the global economy in response to the COVID pandemic is still influencing company earnings today – and may continue to do so for many years. When economies slow, the product inventories of cyclical companies typically build up, and the process of clearing that inventory – for example by offering discounts – dents earnings. In this business cycle, there are some industries where this isn’t happening. Supply is still unable to keep up with demand because supply never recovered from pandemic shutdowns. This is evident in some areas of the semiconductor industry, as well as across the aerospace supply chain.

How consumers keep consuming

Consumer spending has so far remained resilient in the face of rising inflation and interest rates, defying expectation of a cyclical slowdown. There are several reasons for this:

  • Firstly, excess savings remain above pre-pandemic levels, especially in Europe and the UK.
  • Secondly, energy prices have come down from highs seen in the summer of 2022.
  • Thirdly, consumers may be more insulated from the direct effects of higher rates than they have been in the past.
    • In the UK, for example, only 26% of homes are owned with a mortgage, compared with 33% in 2012.

This resilience provides opportunities for stock pickers to find high-quality consumer companies at attractive valuations. The word “quality” is important, as we seek companies that can withstand a potential consumer slowdown once excess savings run dry. We see opportunities across e-commerce, travel and luxury companies, but we focus on quality characteristics such as a strong brand and healthy cash levels.

Slower growth, higher rates, watch the banks

Historically, central banks cut rates when economic growth slowed. Currently, central banks are raising rates into a slowdown as they seek to reduce inflation. Banks are normally thought of as cyclical stocks because in recessions demand for credit may fall and the chances of loan defaults increase. However, higher rates can also be positive for bank earnings as they can earn greater interest on loans.

European bank earnings have reflected this in recent quarters – in Q2, they grew 24% from a year earlier – and we believe this momentum may continue even if the European Central Bank has finished raising rates. Again, we lean towards the quality end of the spectrum, targeting banks with the most attractive dividend and buyback plans.

The forces driving industrials: decarbonisation and deglobalisation

We believe that recent, powerful forces mean the cyclical ups and downs for some industrial companies may be shallower, while the earnings trend rises. Many of these forces can be grouped together into two themes: decarbonisation and deglobalisation.

Decarbonisation: Governments are spending a huge amount on the transition to a lower-carbon economy. Industrial companies are well placed to benefit from this spending. The electrification of cars, trucks, factories, buildings and heating systems, in order to reduce fossil fuel demand, requires the expertise of industrial companies. Industrial companies will be required to build the infrastructure to support the shift to electric vehicles (EVs). Some may be involved in the planning and construction of new battery plants, as well as providing the latest industrial software to enable “digital twins,” or the virtual representation of production processes used in testing. Industrial companies also provide the renovation and insulation capabilities necessary to reduce building emissions – which are responsible for 40% of Europe’s energy consumption.

Deglobalisation: Supply chain disruption during the pandemic highlighted the need for supply chain security. Many companies are choosing to build factories closer to home – either “onshoring” or “near-shoring” production. Government spending amid geopolitical tension is also a boost to industries – such as semiconductors – deemed essential to national security, and domestic production is again being prioritised to secure supply. Bringing production home can be expensive, as one driver for “offshoring” was cheaper labour. And the problem of labour costs is exacerbated in an era of short labour supply and ageing societies. This provides opportunities for industrial companies that specialise in robotics and automation.

The alpha opportunity

To gain alpha - or above market returns - we seek to invest in companies that we believe can over-benefit from some of the powerful themes mentioned above. These are companies that have invested heavily in research and development, have a leading market share and can learn from their dominance in other areas. Many European industrial companies built global leadership positions over the past 20 years because there wasn’t much economic growth in their home market, and that puts them in a strong position now.

*Helen Jewell is CIO, BlackRock Fundamental Equities, EMEA.

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