Q4 Market Recap | The tightening cycle: a Glass Half-Full

Written by?@Anis Lahlou, CIO at?Aperture Investors

We are continuing our initiative of illustrating our quarterly investment letters with an unusual painting. As you know, I am anything but an artist, however AI nowadays is so advanced that Open AI DALL-E 2 Neural Nets are able to generate incredible artworks with simple text prompts. This shows how advanced AI systems see and understand our world, and applications are endless. ChatGPT has also been very popular this quarter, but we are not there in terms of letting it do the work of the investment letter, or not just yet!

The painting below has been generated using the caption “A painting by Ozenfant representing a half-full glass”. Ozenfant of course never painted this glass, and like I said, I am not an artist, but it took DALL-E less than 30 seconds to generate it. Have a look, try it, enjoy it, and tell us what you think!

Equity markets have chosen to go with the story of a glass half-full in the fourth quarter, focusing on pre-empting a Fed pivot.

The tightening cycle: a Glass Half-Full

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” Winston Churchill

MSCI Europe Daily Net TR EUR Index closed sharply up +9.55% this quarter, which is a top 10 percentile quarterly performance for this index since 2001. The CPI miss in October proved to mark the lows for equities for the quarter and the year. It staged a sharp rally driven by a) increasing willingness to pre-empt a Fed pivot, b) rapidly deflating European gas prices, and c) receding systemic and geopolitical risks (UK LDI, GBP, Ukraine, China/Taiwan), as well as d) rising Chinese credit impulse and signs of a sustained re-opening.

As the peak inflation and rates narrative became increasingly supported in the quarter, the US 10 year reached its quarterly and indeed annual high on 21st October. None of the +75bps hike by the ECB on 27th October nor subsequent FOMC meetings were perceived hawkish enough to derail the market rally, especially post the US CPI beat on 10th November.

Banks benefitted from higher rates. Industrials benefitted from an elongated cycle which allowed them to post results above expectations and led to double digit outperformance of Cyclicals versus Defensives (1). It is worth noting that strong market performance was accompanied by a significant short-squeeze. In Q4, the three best performing stocks in Stoxx 600 Index were also among the more frequently shorted stocks as flagged by Prime Brokers (2).

As a result of the strong rally this quarter, the Benchmark Index MSCI Europe Daily Net TR EUR recovered almost half of its peak-to-trough drawdown and closed the year down -9.49%.

How do we think about the outlook?

Of course, there is no shortage of risks as financial conditions continue to tighten and geopolitics remain highly uncertain. However, as explained in part earlier, we would rather look at the glass half-full from there. There are more and more signs that inflation/rates/dollar have peaked, and the Fed pivot is in sight. A major energy crisis during the 2022-23 winter in Europe is now looking increasingly averted.

We understand that part of this argument is already captured in the strong price action of the fourth quarter and that ahead of us lies a delayed response to the Fed’s restrictive interest rate action in terms of economy slowdown. Credit defaults are extremely low, and they will naturally accelerate. With European equities still counting on a 7.5% EPS growth in 2023 according to Bloomberg, we hear the argument of an EPS reset yet to come with pockets of slowdown looming.

Where we are constructive is that we believe the nominal revenue growth will still drive operational leverage and that the earnings reset is unlikely to be anywhere similar to 2000 or 2008 precedents, nor drive stock prices when the central banks pivot is increasingly within sight, at least in the near term. We are also taking into consideration global investor positioning which remains light in international/non-US assets and risk and bodes well for more easing in risk aversion and European equities asset class, where valuation remains very supportive, even in comparison with higher yields in domestic treasuries.

Within European equities, we continue to believe in the long-term benefits of investing in innovation assets as adoption curves continue at a pace. Anecdotally, the world famous CES tradeshow in Vegas just concluded early this year, with over 3,000 exhibitors showcasing innovations in AI, mobility, wearables, VR etc. is a timely reminder of that. From an equity market point of view, more than any point in time, positioning could provide a helpful tailwind to smaller, less owned, more discounted European innovation players.

In our portfolio, we are constructive on the barbell of Innovation and Cyclicality helped by China re-opening and higher-for-longer rates.

We continue to be excited by the exponential prospects of Applied AI penetrating more than the art-cover of our investment letter. We see every day new applications for GPTChat in schools and universities, and we are merely scratching the surface. This is a strong support for our long-term investment case in ASML, the world #1 enabler for leading edge compute and AI, which has erased in 2022 a minimum of 2 years of P/E valuation, while its total addressable end-market has been substantially expanded, not just by the Technology Sovereignty decoupling East/West recently, but also by an underlying Applied AI market growing exponentially. We believe this was evidenced in part in ASML’s Capital Markets Day in November. The company unveiled a forecast of 15% EPS CAGR over the next 9 years, and there could be more to it as their roadmap unfolds.

In Life Sciences, we continue to be excited by the prospects of better drugs that not only help normalise the life of Diabetic and Oncology patients but also pre-emptively deal with Obesity and prevent the devastating and costly complications that most often result from this widespread health issue. This is reflected in our positions in Novo Nordisk and AstraZeneca.

We are taking into consideration the potential for improvement in the business cycle should inflation peak, as was hinted by the CPI numbers in November and December. While this does not mean that we expect interest rates to come down to a low level, we may have seen the peak to Fed hiking and higher-for-longer rates give us comfort in a more sustained re-rating in cheap asset where we have been adding positions, especially in the Financials complex.

We have written this before: “Big Lows” are the ideal opportunities to take advantage of lower valuations. We are one step closer now, and perhaps even closer than our opening quote from Winston Churchill “the end of the beginning”. European and US markets have already corrected by 20-25% peak-to-trough. The glass is half-full. Catching the lows is always challenging as we have experienced in the fourth quarter, but we may still have a good window ahead of us. Have a fabulous year!

(1): GSPECYDE Index +9.3% in Q4.

(2): ZAL GY + 64%, SBBB SS +63%, ENR GY +54%.