Investing in global equity markets has felt like playing a game of dodgeball over the last two years.  Around every corner investors have been faced with a new surprise to navigate. Just as in dodgeball, where players run for cover to avoid the sting of those dreaded balls, equity investors have flocked to the safety of defensive stocks in 2022.  Year to date defensives have outperformed value, growth and cyclical stocks, doing what they are supposed to do in uncertain times: offer equity investors a shield against the onslaught of valuation pressures, slowing earnings growth and increased uncertainty.  As we continue to brace ourselves for ongoing volatility in equity markets, we prefer to maintain exposure to selective stocks with defensive characteristics - those that are winning by not losing.  Deutsche Boerse and Merck & Co are two such examples.

The big de-rating might not be over

Global equity markets have de-rated since the recent peak in September 2020, with a sharper deceleration in 2022 driven by rising inflation fears as reflected in higher 10-year bond yields.   In fact, most major market indices are now trading below their pre-Covid valuation levels.  The derating has been particularly evident in the more expensive parts of the market, such as Technology stocks.  For example, the Nasdaq Composite Index has fallen by -25% so far this year, with most of this occurring through forward PE multiples contracting from ~32 to ~23x currently.  In comparison, the S&P 500 has fallen 16% and contracted from ~22x to ~17x over the same time frame.

All major equity markets have derated sharply YTD to below pre-Covid levels

Source:  Bloomberg, 10 May 2022

Despite this overall market de-rating, most major indices are still trading in line or above their 20-year averages and remain relatively high when considering the sharp rise in 10-year yields (see chart below).  The Russia Ukraine War has also recently pushed commodity prices to new highs, raising inflation risks and potentially placing further pressure on market valuations.

Valuations may be at more risk as bond yields continue to surge

Source:  Bloomberg, 10 May 2022

Investors' fears are shifting from inflation to growth

US GDP has surged past prior cycle peaks but is now decelerating sharply.  Similarly, while 1Q22 earnings were modestly ahead of expectations on average, management commentary and guidance about the outlook has been increasingly cautious, prompting analysts to downgrade earnings forecasts for both '22 and '23.  In fact, earnings revisions breath has been declining since August 2021 and has recently moved outright negative.  Given the wide range of headwinds companies currently face, which include cost pressures, supply chain constraints, inventory build ups and potentially weaker demand from higher prices and lower global growth, it's likely that earnings revisions will remain negative for the foreseeable future.  This has historically been associated with weak overall market performance (see below).

Earnings Revisions and Price are highly correlated

Source:  Alphinity, Bloomberg, 3 May 2022

Earnings leadership has taken another step to being more defensive

At a sector level, we have however seen a sharp contrast with the classic defensive sectors, such as Utilities and Consumer Staples outperforming the overall market year to date, driven by a superior ratings performance as well as better earnings revisions versus their cyclical peers and the broader market (excluding the Energy and Materials).  Defensives have a strong track record of outperforming during slowing growth/recessionary periods, a relative safe-haven within periods of market stress.  With a broad range of defensives already reflecting these benefits in relatively high valuations, active investors need to remain nimble and look for new opportunities.  Some of these might not be seen as typical defensive plays, such as Merck & Co referred to below, but they offer defensive characteristics that should bode well in a volatile environment.  One such defensive earnings leader is Deutsche Boerse.

Just as in a dodgeball game, there are certain times in the market cycle when it is not always about running the fastest, but also about finding the best places to hide.

Deutsche Boerse- Leading stock exchange enjoying multiple cyclical & structural tailwinds

Deutsche Boerse (DB1) is a high-quality owner of various key pieces of financial market infrastructure in Europe across pre-trading, trading & clearing and post-trading.  These assets include Institutional Shareholder Services (ISS), Eurex (leading European financial derivative exchange), EEX (a commodities trading & clearing exchange), Xetra (cash equities) and Clearstream (a leading European settlement & custody provider).  These businesses all tend to command dominant or leading market positions within their segments, and as such enjoy significant barriers to entry and high margins.  These diversified businesses generate resilient mid-cycle digit % secular growth, which we expect to be further boosted by various cyclical tailwinds, including both higher interest rates and higher interest rate volatility, as well as further targeted M&A.  Consequently, we expect the company to exceed management's net income growth target of 10% (CAGR) for FY19-23E.  With positive earnings revisions and a relatively undemanding valuation multiple (current forward PE of ~21x), we continue to see more upside for DB1 in the current environment.

Deutsche Boerse - More defensive Earnings supported by several cyclical and structural factors

Source:  Bloomberg, 10 May 2022

Merck & Co- A high quality defensive with flagship growth products & consistent earnings

Merck & Co (MRK) is a global pharmaceutical company that delivers health solutions through its prescription medicines, vaccines, biologic therapies, animal health and consumer care products. MRK recently reported an impressive 1Q22 result with both revenue and earnings beating consensus expectations and the company raising 2022 guidance for both despite an expected FX headwind, driven by strength across the portfolio. Despite the relative outperformance and re-rating from 10x to 12x YTD, we maintain our position in this flagship defensive at this juncture with two main drivers for our investment case: 1) Product growth of the existing portfolio:  Both the flagship growth products Keytruda (the largest selling drug in the world, innovative immuno-oncology, 30% of group revenues) and Gardasil vaccine (blockbuster vaccine against papilloma virus/cervical cancer, ~9% of group revenues) continue to grow ahead of expectations with their high quality Animal Health business (the third largest in the world) enjoying above market growth rates.  2) Business development:  Management continue to look for new M&A opportunities to expand the business, underpinned by a strong balance sheet, with gearing at only ~2x EBITDA.

Earnings growth underpinned by a portfolio of strong flagship products

Source:  Bloomberg, 10 May 2022

Author:  Elfreda Jonker, Client Portfolio Manager

This information is for adviser & wholesale investors only

Fears that the global transition to a low-carbon economy will drive inflation over the long term are overblown, with the tightening of monetary policy set to have far greater implications for portfolios.

Some observers point to the energy transition as inherently inflationary, with companies compelled to invest less in fossil-fuel energy at a time when the costs for renewable energy remain elevated.

The market has labelled this green inflation - the contribution that environmental policies have on the cost of delivering goods and services that is passed on via supply chains to consumer prices.

In truth, there are a variety of regulations and policies that can influence inflation. The international push-back against globalisation - for example, the continued imposition of trade tariffs - is one of the forces putting upward pressure on prices.

While the pandemic has highlighted the fragility of global supply chains and logistical networks, Russia's invasion of Ukraine has extended inflationary drivers by delaying the recovery process and amplifying commodity price pressures as the war restricts access to energy, metals and grains.

However, the reason that the US has an inflation problem is not due to climate policies, but because its economy was overstimulated as it emerged from Covid-19. The US retained accommodative monetary and fiscal policies for too long, and now its labour market is running red hot.

A multi-year commodity boom in areas of renewable energy that require specialist components - such a rare earth metals - is possible owing to high demand and limited supply. But overall, we don't see green inflation as a meaningful contributor to rising consumer prices over the long term.

Climate policies tend to operate over decades, meaning they're a structural driver of relative prices. However, at an aggregate level, consumers will only ever experience sustained high inflation if major central banks allow that to happen. Even if we were to see sustained commodity price increases, we would not expect headline inflation to remain above central bank targets for extended periods.

We urge investors to look beyond the short term and think about the likely disinflationary consequences of prolonged global policy-tightening in the pipeline.

We urge investors to think about the likely disinflationary consequences of prolonged global policy-tightening in the pipeline.

What we're seeing now is central banks reacting to excess inflation, and we expect them to prioritise anchoring inflation over growth. We don't think we'll be debating green inflation in two years' time, rather the consequences of a US recession that came sooner than expected.

Really, the narrative around green inflation is being driven by what's happening in the West. On the whole, inflation is far lower across Asia Pacific, where climate policy is at a much earlier stage of implementation and there aren't the same constraints on the fossil fuel sector. Moreover, delays in the reopening of Asian economies post Covid-19 has led to more subdued activity levels.

Asia's growing importance

One key question for investors to consider is the role that Asia Pacific will play in the technological innovation required to effect the global energy transition, and whether that will be disinflationary.

From a macroeconomic perspective, policy initiatives by governments and central banks in Asia Pacific have been more prudent, with less willingness to prop up markets artificially. The region has far lower debt levels, fewer constraints on governments and strong state capacity to act. There's tremendous capital available to Asian governments and companies to effect the energy transition.

We believe Asian companies will play an increasingly prominent role in investor portfolios. There can be no energy transition without Asia, where industrial pollution has forced governments to act.

Heavy investment has brought the cost of technology down sharply over the past decade. Solar power became cheaper than coal-fired energy by 2015 in India, enabling it to invest in renewable energy quite aggressively.

We think the technological innovation we are seeing at Asian companies to solve real world problems should be better reflected in portfolios. Some of these companies are working hard to bring down the cost of green hydrogen.

Nowhere is this more relevant than China's highly polluting manufacturing sector, which needs to embrace new energies to clean up entire supply chains.

China wants to do for green hydrogen what it has already done for solar technology and some wind turbine technologies.

We're optimistic, since it will only take progress in countries such as India and China to have a marked impact on correcting some problems the planet is facing. Ultimately, we want to see the power of capitalism and innovation turned towards the global energy transition.

But wealthier nations need to live up to their commitments to assist poorer countries so that they don't routinely get left behind. While China will continue to play a critical role in bringing down the costs of technology, this will take time and poorer countries will need support in the interim.

Of course, asset managers have parameters on what they can and can't invest in. Poor countries often have low credit ratings, governance problems or capital markets not fully formed. We must find a way to mobilise capital to benefit these countries; it's part of the equation that needs solving.

In the near term, some solutions will appear inflationary. Electric vehicles, for example, are more expensive than those with internal combustion engines. Yet electric vehicles is where we see relative prices falling the most - and that's true of a wide range of renewable technologies, such as solar PV.

But forces that appear inflationary today can be disinflationary in future. There will also come a time when commodity prices fall, and as a big commodity importer Asia would be a major beneficiary.

What's incumbent on asset managers when promoting sustainable investments is to communicate that it's a long-term decision. Commodity and fossil-fuel-intensive businesses are doing well because production costs have risen more slowly than prices, which is good for earnings and valuations.

Conversely, valuations among renewables became expensive at times last year because many of the businesses are growth firms, so as the interest-rate structure increased, the discount rate applied to their earnings also increased - leading to significant underperformance.

What it underlines is that investors are likely to experience plenty of variance along the way. Even if you're confident that central banks will get on top of this problem eventually, strategies that seek to manage inflation and volatility will be appealing from a portfolio perspective over the near term.

• Jeremy Lawson and Ken Akintewe were speaking at abrdn's inaugural Sustainability Summit in Singapore on May 24 in a fireside chat entitled 'Green Inflation - Separating Facts from Fiction'.

Author: Jeremy Lawson, Chief Economist, abrdn Research Institute
Ken Akintewe, Head Of Asian Sovereign Debt

Has the RBA hit panic mode?

With rates on the rise, higher inflation and wages below expectation, has Australia's central bank panicked by hiking rates by 50bps, the largest monthly move in over 20 years? The RBA's charter is to ensure the economic prosperity and welfare of the Australian people, which increasingly appears to be being overlooked in favour of an inflation target that isn't easily achievable without causing recession.