US Equity Perspectives - Positioning for a hawkish pivot
#Market Strategy — 17.01.2022

Positioning for a Hawkish Pivot

US Equity Perspectives, January 2022

Alexis Tay, Senior Adviser Equity Advisory Asia

Summary

The FOMC[1] December 2021 meeting minutes revealed the US central bank might start raising interest rates from record-low levels sooner than expected and reduce its overall asset holdings to tame high inflation. This hawkish pivot is significant and markets reacted negatively. So how should investors position themselves?

Avoid expensive growth stocks

  • Going into 2022, we have turned neutral on the overall market given headwinds around peak liquidity/stimulus, peak economic momentum/ earnings revisions, coupled with high valuations. In particular, we are cautious on expensive growth names with high valuations, especially unprofitable tech companies.

Focus on Financials, Energy, and Healthcare for immediate opportunities

  • Healthcare – We think the sector should be more resilient against a choppier market. Particularly, we have a bias towards the more defensive pharmaceutical space – an area with valuation attractions, balance sheet support, and above-market dividend yields.
  • Energy is a sector that continues to benefit from tight global supply-demand dynamics, and can offer better inflationary hedging characteristics than the broad equity market in the near term.
  • Within Financials, we particularly like the big banks, where a more aggressive interest rate hike cycle would support net interest income expansion.

Opportunity to buy reasonably priced large-cap Technology stocks on dips

  • Within the tech sector, valuation remains the key investment driver. We continue to like tech megacaps as valuations in general remain undemanding.
  • We think software has more room to correct, given sector valuation as a whole remains much more elevated compared to other segments. There are also concerns that software demand has been pulled forward over the last two years due to Covid-induced accelerated digitisation trends. Nonetheless, we would see this pullback as good opportunity to buy on dips quality large-cap names with reasonable valuations and strong competitive moats.
  • Within semiconductors, we turn more selective. The chip cycle is likely to transition from inventory depletion to build-up over the course of 2022, which should make it a choppier year compared to 2021. However, for the next few quarters, there remains an upside bias to earnings estimates as supply constraints lift and investor positioning/expectations remain light. Our preference stays with compute names.

Fed's hawkish turn sparks growth stock selloff. How should investors position themselves?

The FOMC December 2021 meeting minutes revealed the US central bank might start raising interest rates from record-low levels sooner than expected and reduce its overall asset holdings to tame high inflation. Officials saw the timing of reducing the USD8.8 trillion balance sheet as likely “closer to that of policy rate liftoff than in the committee’s previous experience”.

Policymakers also noted that the outlook for the economy and the labour market had improved despite the risk of new variants of the virus, while elevated inflation had persisted for longer than they had previously anticipated.

Markets have reacted negatively to this hawkish twist, with the S&P 500 Index and the Nasdaq Composite Index correcting 1.9% and 3.3% respectively overnight. Underneath the surface, high-growth stocks suffered an even greater hit, with many correcting more than 5%.

Avoid expensive growth stocks

Going into 2022, we have turned neutral on the overall market given headwinds around peak liquidity/stimulus, peak economic momentum/ earnings revisions, coupled with high valuations.

In particular, we are cautious on expensive growth names with high valuations, especially unprofitable tech companies. These companies have benefitted the most from liquidity-induced rerating, and have potential to correct the most in a broad market correction, either sparked by higher rates or earnings disappointments. Many of these long duration names continue to trade at price/sales ratios of 30-50x, offering little valuation protection on the downside. We advise investors to continue to avoid this space.

So where should we focus on for immediate opportunities?

Focus on Financials, Energy, and Healthcare

We see opportunities in Healthcare, as we think the sector should be more resilient against a choppy market given its defensive nature. Moreover, the sector’s relative P/E1 (against S&P 500) remains at multi-year lows (see Chart 1).

Our bias within healthcare would be towards the more defensive pharmaceutical space, particularly since this is an area with valuation attractions, balance sheet support, and above-market dividend yields. In addition, a few major US pharmaceutical companies are exposed to the ongoing Covid story through the provision of vaccines and therapeutics.

Conversely, we would expect more volatility within the biotech space, as long-duration growth stocks become more challenged in an environment of rising rates.

healthcare sector

Energy is a sector that continues to benefit from tight global supply-demand dynamics. Although questions remain surrounding the alignment of US names to the long-term energy transition theme, we would expect sector names to offer better inflationary hedging characteristics than the broad equity market in the near term, particularly with continued above-trend economic growth.

Within Financials, we particularly like the big banks, where a more aggressive interest rate hike cycle would support net interest income expansion. In addition, trading and investment banking activities have remained buoyant, helping to offset challenges in loan growth. Banks are also well placed to enhance shareholder payments through dividend increases and share buybacks in 2022.

Opportunity to buy reasonably priced large cap Technology stocks on dips

Within the tech sector, valuation remains our key investment driver. We continue to like tech megacaps as valuations in general remain undemanding.

Meanwhile, we have turned more selective on semiconductors. The chip cycle is likely to transition from inventory depletion to inventory build-up over the course of 2022, which should make it a choppier year compared to 2021. Nonetheless we think for the next few quarters there remains an upside bias to earnings estimates as supply constraints lift and investor positioning/expectations remain light.

On the ground, we are seeing mixed performance for different segments of the industry. Strongest trends are seen in compute, while autos and semi equipment trends are likely to pick up as supply chain issues ease. On the other hand, we remain neutral on smartphone and memory names. Our subsector preference remains: Compute > Autos, Semi Equipment > Handsets, Memory.

As for software, we think the sector has more room to correct, given sector valuation as a whole remains much more elevated, compared to other segments such as semiconductors and the megacaps. There are also concerns that software demand has been pulled forward over the last two years due to Covid-induced acceleration of digitisation trends. Nonetheless, we would see this pullback as good opportunity to buy on dips quality large-cap names with reasonable valuations and strong competitive moats.

The Software Playbook

2021 was a rather challenging year for the software sector. After an initial period of volatility in early 2021 and subsequent recovery, software has sharply underperformed the overall market since October 2021 (see Chart 2). This was led by weakness in many high growth/high valuation names which were impacted by fears over rising rates.

Interestingly, there has been heightened divergence of performance between top and bottom quartile software players over the past two years, with the bottom quartile suffering from negative returns for the first time since 2016.

Nonetheless, we think the recent correction has opened up opportunities for investors, especially in the high quality names with reasonable valuations. There are also selected bottom fishing opportunities in long duration names which have derated significantly and where valuations look balanced against medium-term revenue growth profiles.

us software sector

Overall, software fundamentals will remain resilient in 2022, with secular trends in Cloud computing, Security, AI/Machine Learning, data analytics and digital transformation firmly in place, and chief information officers (CIOs) expecting ~5% growth in software spending in 2022 (according to a recent sell-side survey), roughly in-line with 2021.

Although overall enterprise software spending remains robust, there are concerns that software demand has been pulled forward over the last two years due to Covid-induced acceleration of digitisation trends, especially in the front-office/creative software segments. Meanwhile back-office software spending has lagged and probably has room to play catch-up. Meanwhile, Cloud and security spending remains robust.

We think 2022 will continue to be more of a stock picker’s market given software multiples remain elevated, difficult year-on-year comparisons in 1H22, as well as rising interest rate risk. Software companies may also see modest margin compression as hiring and travel expenses increase. On valuation, even after the recent pullback, the current EV[2]/sales multiple of software names remain >50% ahead of the historical 5-year average.

Picking our spots

We find several themes in play within the sector:

1) Software names which are M&A[3] driven and trading at discounted multiples

These are software names that have traditionally grown by active M&A, instead of just relying on organic growth. While we do think some discount is warranted given the execution and integration risks involved in such a growth strategy, we also think that software companies have grown in their ability to acquire and integrate new assets. As such, discounted multiples can create opportunities.

2) Enterprise back-office related software/Cloud

Enterprise software spending was weak in the early recovery period after Covid-19 hit, being more impacted by Covid headwinds, but it has been strengthening over the past quarters as budget dollars return. We think back-office software has lagged overall enterprise software and has room to catch up in 2022. Meanwhile we have seen major US cloud service providers’ revenues reaccelerating in recent quarters.

3) Bottom fishing names

Underperformers in 2021 included companies that were more geared towards the Covid economy e.g. video conferencing, as well as high valuation names where results and guidance, though still strong in an absolute sense, did not match up to elevated expectations.

Some of these stocks have fallen more than 50% off all-time peaks, and there are opportunities in companies where the significant derating looks attractive compared to medium-term growth potential, though an inflection point in share price performance may still require some patience.

1 FOMC = Federal Open Market Committee

2 EV = Enterprise Value

3 M&A = Mergers and Acquisitions