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“Nature hates miracles that take too long”

“Nature abhors miracles that last too long,” wrote Camus. 
How long can the one unfolding before our eyes last?
Inflation is losing ground, but neither the rise in interest rates nor the slowdown in activity in Europe and the United States has led to an even perceptible rise in unemployment! Surprisingly, it remains at its lowest level: 6.5% in the euro zone according to Eurostat, 3.6% in the US. 

The labour market thus remains vigorous, wages are rising, particularly in Europe, increasing the fixed costs of companies. This puts pressure on margins… But for companies, it is also a necessary investment in a demographic context where the workforce is becoming structurally scarcer (19,000 fewer births in France in 2022), while the costs of acquiring and rotating talent are increasing. Is the miracle of soft-landing, the containment of inflation without job destruction, being accomplished before our incredulous eyes?

The German Chancellor wants to believe it: the economic slowdown may be weaker than expected, Germany should prodigiously escape the vengeful god of recession, he believes, despite the sin of making a pact with the Russian devil. 

Nevertheless, activity in the fourth quarter has slowed: chemical company BASF (which succeeds Covestro in the disappointment of downward earnings revisions) is suffering from a decline in volumes that cancels out the positive effect of price increases charged to customers. 

Moreover, with the fall in raw materials and inflation indices observed or anticipated (German breakevens are back around 2%), customers may be less inclined to accept additional price increases in the future. 

In the consumer sector, in France, Fnac Darty reported a €55 million drop in sales in December, a key period for the retailer. American Procter & Gamble concedes a 6% drop in volumes in the last quarter. 

In the meantime, investors should continue to see the inertial effect of inflation in recent months on the costs of goods sold (COGS).
A similar trend can be seen in Continental’s Contitech division, which is disappointing both in terms of margin and cash flow. The continuing strong increase in inputs between September and December of last year is having an impact.

Within an industry sector, some companies will do better than others and take advantage of their competitors’ weaknesses during an economic downturn to strengthen their competitive advantages and gain market share when the economy recovers.

According to Mckinsey, in a study of 1,200 companies, historically, investors have favoured management during earnings downturns that have made the following decisions: increased retention of earnings (reduced dividend payout or reduced share buybacks), reduced leverage, rapid reinvestment of retained earnings in R&D, Capex and M&A. 

Above all, the study concludes that a strategy based on simple cost cutting is counterproductive. 

Microsoft’s decision to reduce its payroll by 5%, or 10,000 employees, may protect its margin in the short term but could penalise the group’s competitiveness in the event of a faster or more dynamic recovery than expected, such as the one that followed the first series of confinements. 

Thus, after a particularly favourable year for systematic funds, stock-picking could return to its glory days in 2023. 

For investors, after this historic start to the year on the European markets, alpha may now be more important than beta. 

In this respect, the 12% gap between Morgan Stanley and Goldman Sachs on the same day as the publication of their results last Tuesday is telling. Does it herald a year that will be more about fundamental stock selection than sector positioning, as was the case in 2022?

With high valuation spreads (the implicit cost of equity of Société Générale, Barclay’s reaches between 23 and 25%, against an average of 17%), the European banking sector (50% discount to the rest of the market!) could offer the same spectacle as on the other side of the Atlantic. 

The Spanish and Swedish banks open the ball of publications. The first to publish Bankinter offers a mixed picture: most of the benefit of the rebound in interest margins (which has allowed analysts to raise their revenue expectations for the sector by 90 billion euros over the combined years 2022 and 2023) is being consumed by rising operating costs. 
Although the sector is not (directly at least) exposed to the commodity rebound, rising salaries and IT modernisation project costs are a real issue for both US and European banks.

Especially since Western finance no longer reigns supreme. 
The sovereign wealth funds of Saudi Arabia, Qatar and Abu Dhabi now manage $3.5 trillion, which is more than the UK’s GDP. First Abu Dhabi bank PJSC has even considered buying Standard Chartered. 
In 2022 alone, Middle Eastern funds invested $90 billion, of which $16 billion was in Europe, half the amount invested in the US… in contrast to the current positioning of asset managers: as Bank of America notes, not so few have been overweight US equities since October 2005.
With up to $1bn of oil exported per day by 2022, Saudi Arabia’s difficulty lies more in finding targets than in financing its acquisitions. Rising oil and gas prices have boosted the reserves of sovereign wealth funds and their investments in oil importing geographies… 

The WTI quality barrel has been recovering for a few sessions. Until October 2023, all futures maturities are now quoted above $80. The resilience of the European economy and the latest high-frequency data from China support the rebound of mobility energy. 

The Chinese are learning to live with the virus: attendance at public places (such as cinemas) has started the year strongly. Traffic congestion in cars and in the metro is up by 50%. With some estimates putting the rate of contamination at 40%, we can think that the peak will be reached with the celebration of the new year and that collective immunity can be observed more quickly than expected (from 30 days…) 

According to Goldman Sachs, the current Brent price does not include an increase in oil demand from China and assumes a stable Russian supply. 
But like the banking sector, which remains very little owned despite a good start to the stock market, oil prices transpire a mistrust of economic growth among investors that is not unjustified, especially when they reason in “bottom-up”, i.e. by observing the commercial activity of companies, particularly in the consumer sector. 
On the contrary, the most optimistic scenarios are accompanied by a threatening sword of Damocles. Could a more resilient Western economy than expected and Chinese growth above 5% in 2023 trigger a return of the overheating that central banks have been struggling to combat for over a year?  

This is perhaps the reason why, seeking to dispel rumours of hikes of just 25 basis points, the ECB’s teams have taken turns to reinforce the institution’s hawkish discourse. Christine Lagarde proclaims that the fight against inflation is not over. François Villeroy de Galhau asserted that resilience should reinforce the institution’s ability to deliver the planned rate hike. Philip Lane argues that it is imperative to move into restrictive rate territory. Pablo Hernandez of Cos guarantees significant increases to follow. Finally, Olli Rehn professes that “by acting quickly now, we would be able to protect ourselves from a Volcker shock”.

Given these letters of commitment, the main risk today is that the markets have moved a little too quickly towards a monetary pivot.  
The ECB rate of 3.25% expected in May seems justified, but is it reasonable to expect a cut as early as June? Is this compatible with the emerging economic resilience and the potential rebound of China, the largest importer of raw materials? Is it a miracle or an illusion to return to accommodative territory after just one year?  

Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in January 20th, 2023.

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