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4 September 2019, Sweden | Mutual Funds | News

Outlook autumn 2019

Global stock markets are hanging in the balance. There are plenty of clouds, including weaker macro indicators, trade wars and Brexit. Will we slide into recession, as many believe?

No, at least not according to Catella Fonder's fund managers who recently met to discuss developments this autumn and further ahead. The central banks will – once again – step in and take action.

There have been many recent signals that the economy is moving into a clearly weaker phase than the strong performance of the past two years. Leading indicators have in many cases made bleak reading, and the strong world economy fuelled by US President Donald Trump's tax cuts and Chinese stimulus seems to be faltering.

However, Catella's fund managers Thomas Elofsson, Martin Jonsson and Anders Wennberg, the first of whom works with fixed income and the others with equities, do not believe that events will lead to any deep recession.

Thomas Elofsson points out that there has been unusually synchronised global growth for some time, but that the economy has now settled to more normalised levels. But there are plenty of question marks about the future. 

"Normally in this situation, we would expect a bottoming out and a turnaround, but the question is whether it will happen this time given all the disruptions such as trade wars and Brexit. In addition, the central banks are perhaps less potent this time around since interest rates are so incredibly low and it is so late in the economic cycle," says Thomas Elofsson.

The US Federal Reserve appears to be the central bank that currently has the greatest scope for stimulus after upping its policy rate for some time, until the recent cut to the current range of 2.00-2.25 percent. Despite the increase in January, Sweden's repo rate is negative, at -0.25 percent, while the ECB's key rate is 0.00 percent.

"These levels are clearly very low, but my guess is that more will still be done – both in Europe and in Sweden. The real question is whether this will actually help the economy? I would say not, but on the other hand it would have a very big impact on the market," says Elofsson.

Saving in fixed income securities has been difficult in recent years, with the uniquely low interest rates, which is why other forms of investment have taken over – the flow of money into equities has continued because in practice there are no real alternatives. This trend is likely to continue, the managers believe, and if central banks once again act with stimulus it will be reinforced.

Elofsson says that the main impact of any future stimulus will be its influence on market sentiment.

"This is a tricky situation. If there is a recession, the big discussions would centre on what could be done. I do not believe the central banks would be entirely toothless, so there would be new stimulus and probably quite a lot," he says. 

Anders Wennberg points out that many sectors, such as automotive and semiconductors, have long shown weak figures and declining volumes. In these cases, the stock exchange could also gain support in the form of easier comparison figures in the future – the improvement would not have to be very big for the comparisons to look a little better.
"At some point there will be easier comparison figures as well, and I expect there to be some kind of stabilisation in some sectors," he says.

But can there really be a recession in a market with negative interest rates and full employment?

"When pricing the stock market, you have to take into account the probability of a recession, and if the probability is increased then share prices need to be adjusted. Will there be a recession? When interest rates are so enormously low and central banks absolutely do not want to see a downturn, the risk is fairly low," says Elofsson.
According to Elofsson, the real concern would instead be if economies started to show signs of rising inflation.

"In that case they would not be able to maintain such expansionary monetary policy. But as long as inflation is so low, and we have to assume this, central banks have something of a carte blanche to do as they wish. This makes the likelihood of a real meltdown pretty low," he says.

However, Martin Jonsson offers a warning and points out that the effects of political interference can be difficult to foresee. Especially with an unpredictable person like Donald Trump in the White House.

"The situation is fragile. The economy cannot withstand just any amount of more or less active sabotage, like these tweets about trade wars or perhaps Brexit. Last week it was possible to discern a bottoming out of some leading indicators. But if there are more burdens like tariffs and increased upsets, the recovery we hope for may not come," he says.

The flight of capital from fixed income securities to equities has driven up share prices for several years. It is mainly shares in what are perceived as quality companies that are being pushed ever higher in pursuit of the safest possible returns on the stock exchanges.
"Bond money moving to the stock market has pursued defensive stocks to very high levels. Many stable companies have P/E ratios around 25, while companies with a little more cyclical risk have been priced down considerably because people are very nervous about this kind of share. The spreads between valuations on the stock market are the largest since 2000," says Anders Wennberg.

The P/E ratio is currently around 15 for the stock market as a whole, but there is a big range. Defensive companies are often up to P/E 25, while cyclicals might be below 10, adds Wennberg.

Have you identified the valuation gap and decided to invest more in stocks with lower valuations?

"Quality stocks should have a higher valuation given the lower risk and less volatility in earnings, but the difference has widened to an extreme. We have therefore started to wonder whether there will be a correction. Indicators like the purchasing manager index, PMI, look to be levelling out a little and we will also meet easier comparison figures in the fourth quarter. Assuming nothing serious happens in the trade war, we think there may be a slight cyclical recovery," says Wennberg.

Meanwhile, not all stocks deemed defensive are equally safe – some companies have their own problems. For example, Catella Fonder is shorting Norwegian fish producer Mowi, which was formerly called Marine Harvest. The company's profit forecast is down 20 percent this year and the salmon price is the lowest in three years due to large supply. At the same time, there has been some cost inflation from more expensive fish food and higher costs for treating diseases.

Despite this, the Mowi share has risen by around 20 percent this year.

"Profit forecasts are down 20 percent and the share is up 20 percent, taking it from P/E 12 to P/E 17 this year. The Norwegian market is heavily weighted towards oil and oil services, and there is a shortage of defensive stocks," says Wennberg. But he believes the trend will turn.

"We feel we have gained a tailwind given that the estimates have fallen and in the latest report the profit forecasts were down another 6-7 percent. The share has also started to come down," he continues.
Regarding long holdings, Jonsson highlights Swedish steel company SSAB, which has been down-valued to levels similar to the period after the Lehman Brothers crash.
"SSAB is starting to get interesting. The share is valued lower on EV/sales than it has been for 15 years. This implies that profitability will be record-low, and we do not see that – profitability is the highest since the financial crisis. It will come down, but not to the levels the market believes. Its balance sheet is much stronger than three years ago, when we last had very low steel prices in Europe. Added to that are steel tariffs in the US, where SSAB has a large part of its earnings. And SSAB is a player in special steel and heavy sheet, while the weakness in Europe is driven by the automotive side and light sheet," says Jonsson.

As to many other industrial companies, Jonsson believes that analysts still need to lower their estimates. He points out that many are still expecting sales growth next year for companies such as Sandvik and SKF, which he sees as unlikely. But if leading indicators shift slowly upward, it may not matter that much whether profit estimates for the companies are lowered by another 5 or 10 percent – the shares could turn anyway.
"We have long positions in Sandvik and Volvo, but it's not a huge exposure," says Jonsson.

The companies that are most sought after by the market today, the quality companies, are characterised primarily by low volatility in their earnings. On the other hand, growth for these companies can often be relatively low, in line with inflation or perhaps not much more. It is to these shares that the money from fixed income is going.
"These are the ones that are most similar to bonds – bonds are what are most manipulated by central banks and most overpriced. If you are withdrawing your money from there to move it to something with low risk, then shares like Ica fit very well," says Wennberg.

What premium is being placed on dividends right now?

"Ica and that type of share have traditionally paid very good dividends, but since the stock market has risen the dividend is not as high anymore. It is around 2.4-2.5 percent, which is a little below the stock market in general," says Wennberg.

But it is not only the stand-out quality companies that are being upwardly valued on the stock market. Growth companies should also be included in this category. The further interest rates fall, the more valuable growth companies with their cash flows far in the future become.

"These might be quality companies, but also junk companies that are currently making big losses with hopes for profits in the future. This type of company is being upwardly valued at the expense of those that actually make a lot of money today but where there is doubt about how their business model will function in ten years. We think the rubber band has been stretched too far," says Wennberg.

What's not at all popular on the stock market right now are companies with cyclical risk. As Jonsson describes it, growth is becoming an increasingly scarce resource – the more you worry about the economy, the harder it is to find shares that are certain to grow in the future. Shares like this are being upwardly valued.

The question is what could act as a trigger for the stock market going forward. A conclusive resolution to the US-China trade war would be the ultimate trigger, says Wennberg, but besides that, a stabilisation of different purchasing managers' indexes could also give momentum to the stock market. Or that the world's central banks act quickly and vigorously so that, for example, the Federal Reserve lowers interest rates more than expected.

"We are in a somewhat strange situation. The fixed income market is pricing in a recession, pure and simple, but the equity markets are generally not. I think this is because of what the central banks have done, by pushing down interest rates. The market is pricing in much more monetary policy stimulus than there has been thus far. In order to deal with it they have to be more aggressive now – if they're going to cut it is better to cut big, now," says Elofsson.

Although the US central bank has the advantage of having been able to raise interest rates a bit, unlike central banks in most other countries, he does not believe that the Fed is alone in being able to act vigorously in the future.

"The ECB, I believe, will certainly both lower interest rates and increase its QE purchases. If the market thinks this is sufficient, things could turn around quite quickly," says Elofsson.

Jonsson agrees, and points to Germany as an important country to watch.
"Germany is something of an epicentre for the economic weakness. The country is basically in recession, with huge weakness in car exports that are far below the levels of 2012 or 2015. Comparative figures for car sales are extremely tough in August, but in September they are easy and become even easier, so there will be positive figures. I find it difficult to see that the GDP figures in Germany will not receive a boost during the second half of the year," says Jonsson.

How do things look for sectors like e-commerce – do you still have positions there?

"We still have Boozt, and still believe in it. It continues to grow at a very good pace organically and is sticking to its full-year guidance of 27 percent growth. The gross margin is still falling, but at a slower rate; it has cut back on marketing. There is no doubt that it is growing apace, the question is where the long-term margin lies. We are staying put and believe it will win market shares in the long term," says Wennberg.

Banks have also been pushed down. Do you have Nordea?

"Banks are generally at very low valuations, in both the Nordic countries and Europe. With this interest rate environment and other concerns such as money laundering, there is no bright prospect for the banks as a whole, but we have tested a long exposure to Nordea. This bank has a new chairman who is leaving no stone unturned, and there will be a new CEO next year. It is holding a capital markets day this autumn as well, with new financial targets, which we believe will mean new cost savings at the bank," says Jonsson.

He adds that, when it comes to Nordea, the market often overlooks the effect of the bank's legal move to Finland, which means it is now under the EU's regulatory system. This could provide relief on the capital side, according to Jonsson, who believes that in future the bank could lower its dividend share to a more sustainable level and still provide attractive dividends and build capital, possibly resulting in, for example, share buybacks.

When it comes to interest rates, Elofsson believes that the prevailing environment of extremely low rates will persist for the foreseeable future. In the case of Sweden, he thinks that the Riksbank's next change to the repo rate will be a cut.

"The Riksbank itself currently forecasts a raise to interest rates, but I think the next movement will be a reduction. Not because it likes to cut rates but because inflation is low, and as growth slows the inflationary pressure will be even lower. If the ECB does more than people are expecting, the Riksbank will have to follow suit," says Elofsson. But he does not expect these measures to benefit the world economy in the long run.

"It's a hugely tricky situation, with valuations having been stretched a very long way."

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Anders Wennberg

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Martin Jonsson

Fund manager
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Thomas Elofsson

Head of Portfolio Management, Fund manager, and acting CEO of the Company
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