Focus on Earnings, Valuations amid Economic Uncertainty

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Murdo MacLean, client investment manager at Walter Scott & Partners in Edinburgh, Scotland.  

As ever, the state of the global macro environment is very important, and clearly we have been going through a bit of a transition over the last couple of years. From the Covid environment into the sort of rebound, higher inflationary environment, and then into something now where, I think it appears as if the battle against inflation is being won. But there are also question marks around the direction of travel for the global economy, whether we will dip into recession or whether we will avoid that. And of course, that will differ by country.  

I think certainly the state of the macro is a key element driving global equities. And at the same time, obviously connected to that, I suppose is, and this has been the case for several years now, the direction for interest rates. And again, given, I suppose, the importance of the U.S. market to global equities, the actions of the Federal Reserve are the most important and have a ripple effect on other central banks and sentiment more broadly. So, I think that’s something that we continue to need to watch.  

You have factors such as the U.S. presidential election and all the potential ramifications that that will carry. And you have also geopolitical tensions, which continue to rumble on, whether it be in Russia, Ukraine or the Middle East, or the sort of elephant in the room which is the U.S., China, although not at war, clearly, there are tensions there.  

The other factor, which we think is much more important over the long term, is corporate earnings. And tied to that, valuations. And I think that that is something that in light of the fact that many of the other factors are out of our control, that is the key area that we focus on.  

What are corporate earnings going to do, specifically around the companies that we own or would like to invest in, and then what are we being asked to pay for that earning stream in terms of valuation. I’m sure that there are other factors, most of them will be short term in nature, because the long-term overarching driver for equity markets is earnings at the company level.  

More specifically on geopolitical risk, it does depend on the specific sort of geopolitical tensions you’re referring to. I think to a large extent, the unfortunate issues in Ukraine, although still very important I think politically, from a stock market perspective are probably less important today than they were in the initial months or weeks after the escalation. And I suppose that’s typically the case with most geopolitical tensions that don’t necessarily involve large economic superpowers, but nonetheless have humanitarian impact.  

I think the Middle Eastern conflict as well, although still probably has the ability to shape markets from time to time, does not perhaps directly impact the revenues or profits or earnings of most of the larger businesses around the world. If you are invested in Israeli businesses, for example, it may well be that you feel that more keenly. But I think for a lot of the large U.S. companies or Asian businesses, the percentage of revenues that they are gaining from Israel and the Middle East and so on will be small. Will be in the low single digit range, if at all. And so, the market will look through that, I think, and it’s more down to whether these conflicts will have an impact on commodity prices or oil and gas prices, as was the case with Russia, for example. Whether it creates a supply chain issue.  

The ongoing tensions between the U.S. and China are probably here to stay. So, it’s not a current as much as a new norm. You know clearly you have two economic powerhouses, one seeking to preserve their position at the top of the order, and the other one seeking to challenge that. And there are clearly industries where that is being felt significantly. I suppose, most notably semiconductors.  

Because we’re on the sort of precipice, or I should say, perhaps the eve of a U.S. presidential election, I suppose that raises the stakes a little bit more, because of the uncertainty as to what potential policy changes we see, whether it’s a Democratic or a Republican president in office.  

We have seen U.S. technology be extremely dominant, approaching levels that you don’t expect to be necessarily sustainable in the future. There is a risk there, but also therefore other sectors that are being overlooked.  

Health care, which we know to be a long-term growth sector because of the supporting demographics, has been quite patchy. You’ve had, you know, huge successes in the area of obesity care, with likes of Lilly, for example, and Novo Nordisk, obviously, in Europe. But you’ve also seen areas of life sciences, for example, biotechnology, medical devices, having a much more bumpy ride. Dealing with a higher cost of capital environment, dealing with post pandemic, as it continues, bottlenecks to labour, to availability of hospitals, et cetera, they have had a far less smooth, I suppose, journey from the pandemic years.  

Particularly in the U.S., we’ve seen a softening of the industrial space. So, I would say companies that we are quite familiar with, such as Fastenal, the U.S. distributor of fasteners, companies like Canadian National Railroad, and, for that matter, most of the railroads that are obviously a bit of a proxy for the North American economy. To that extent, also Old Dominion Freight Line (ODFL), which we also know well, again will reflect the health and the confidence of the underlying economy and the participants within that. And certainly over the last quarter or two, we’ve seen companies in those spaces, including the ones I mentioned, call out a softer U.S. industrial landscape, and I think that is something that we need to keep a close eye on.  

I think in the long term, those companies all play a really important role in what are growth industries and are at the forefront of innovation and so on, but they still reflect a softer economic backdrop.  

And I suppose in the consumer space as well, we’ve seen a general weakening in the performance of some of the consumer companies out there. I think in our portfolios, we’ve noticed that at the luxury, the high end of luxury, there’s certainly been a cooling. I think that’s probably to be expected, given that we saw really strong consumption patterns in luxury post pandemic, as a bit of a revenge sort of spend trend, but that, I think, is cooling and normalizing now.  

The same goes for travel. I think Booking.com and no doubt Expedia is also seeing the same sort of currently healthy trends but the outlook is less certain.  

I think, as across the retail landscape, a real mixed bag, Costco continues to do really well and has this sort of secret sauce that’s very hard to replicate. You see the likes of TJX, the parent company of T.J. Maxx or Marshall’s, Winners, a company that’s done very well historically from softer economic periods, continue to put down good numbers. Inditex, the parent company of Zara and other sub brands, also doing extremely well, having obviously a good value proposition to the customer.  

But then businesses that we don’t necessarily invest in but that we know well, such as the dollar stores, have had a turbulent last few weeks and days, and in fact, year-to-date they’re among some of the weaker performers. And that is interesting, because they historically have been pretty resilient in weaker economic environments. 

We must be cautious around businesses that are trading on valuations that historically look high, and then take care to analyze what it is about those valuations, what is driving those valuations to be so high.  

And I think it’s hard to look beyond pockets of the technology sector. The poster child for the rally of the last few years has been Nvidia, and it is a wonderful business. It’s experienced absolutely phenomenal growth. But as we saw when it reported over a week ago, some of the guidance around margins, the market did not like it. So, it’s a double-edged sword. The better you do, the more demanding the market will become about your stock.  

And then, because Nvidia has such an impact on other stocks in the technology sector, the contagion, I suppose, risk there is quite significant across businesses that are in the same domain as Nvidia.