Investor sentiment is the main market driver in the short term, which is why everyone cites different statistics to underpin their views. Admittedly, the signals can be conflicting. Our current take is that sentiment is back to neutral in the short term, which means that the real buying opportunities were in October 2022 and March 2023. That was, as usual, the time when no reasonable investor dared to buy stocks.
As to the medium-term prospects, the positioning data does not indicate that investors are warming up to risk. Many of the surveys in which investors are signalling their mood for risk are wishful thinking, reflecting their dream asset allocation. In real life, the mantra is: ‘wait for a setback to get back in’. This makes it harder for any entry points to materialise, as the majority is waiting for them.
Investing for longer duration may pay off
Where does that leave investors for now? In limbo, of course – as usual. Hardly anyone seriously dares to go into a ‘lessons-learned’ session with the person in the mirror. Yet if they did, the outcome would likely be to concede that only very few are made to call the bottom in stock markets and that, for the rest, trying to do so is futile.
The more upbeat takeaway is that this frees investors from only buying when the walls come tumbling down. Instead, they may simply want to seize the medium-term opportunities.
Over the coming days, central banks will dominate the agenda. The indications are that, overall, that rates are at, or beyond, their peaks. Fixed income could well benefit in this context, as longer duration pays off. But the same holds true for growth stocks that were hammered due to fears of relentless rate hikes. We keep hunting high and low for bargains.
Small caps floating behind large caps
One hunting ground for investors lately is companies in the small-cap space, that is, those with a market value of between USD 250 million to USD 2 billion. These small caps have underperformed their large-cap counterparts (market value of more than USD 10 billion) by roughly 7% year to date. After the phenomenal performance of the large-cap US growth names, which were responsible for most of the positive performance year to date, interest in picking up some laggards has increased.
Admittedly, valuations in the small-cap space do look appealing. The global small-cap index is trading at a 12-month forward price-to-earnings ratio of 16.2x, close to one standard deviation below the ten-year average. That said, the valuation does not consider the fact that approximately 25% of the companies in the global small-cap index have negative earnings.
Moreover, the profitability gap between the small- and large-cap space has further increased over the past years. Large caps show on average a return on equity and profit margins twice as high compared to small caps.
What worries us the most at this stage of the cycle, which is characterised by higher interest rates and slowing economic growth, is the debt profile. In the US small-cap space, roughly a third of the outstanding debt has been issued at floating rates, making it quite vulnerable if rates stay higher for longer.
Against this backdrop, we would refrain from increasing exposure to small caps despite attractive valuation and suggest sticking with the large-cap growth names, which should continue to do well in the current market environment.
Back to the future on the European energy market
What a difference less than a year makes on Europe’s energy market. Prices are almost back at pre-crisis levels. With ample global gas and coal storage and an accelerated energy transition, energy has moved from scarcity to abundance, and the willingness to pay for energy is slumping. The market is transitioning swifter than expected from a sellers’ to a buyers’ market.
Amidst these exceptional market dynamics, two observations stand out. First, the shock waves seem to be leaving the value chain. Wholesale prices swiftly normalised and began to settle close to pre-crisis levels earlier this year. Retail prices lag but are following similar trends surprisingly swiftly. Moreover, household electricity prices seem to be easing in most liberalised markets thanks to competitive forces.
Second, a closer look at past weeks’ electricity flows reveals the emergence of dynamics related to the energy transition. Over the past month, prices turned negative on roughly ten occasions in Germany. Abundant renewables and nuclear generation forced flexible thermal and hydro out of the north-western European system.
The clean energy momentum is strong, especially the growth in stationary batteries. That said, there are similarities to the period around 2015. We see risks of a cyclical gas and electricity price trough and business consolidation before 2025.