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What fighting inflation means for stock markets

After staging a rally in July that saw global equities rise 9.7%, markets reversed in August and fell 2.3%[1] to continue their downward trend for the year. Stocks have fallen as central banks – notably in the US – have toughened their stance against inflation and investors are concerned about the impact of rising interest rates as economic growth stalls in many countries.

The threat of a widespread recession has grown as consumers curb their spending in the face of rising energy and food prices. Confidence has dropped to levels last seen during the global financial crisis in major economies (see chart), inevitably dampening business expectations. Such pessimism, however, is often positive for forward-looking investors, as Jonas Edholm, Portfolio Manager of SKAGEN Focus, explains: "Sentiment has been deteriorating for months and the current gloom is largely priced into company valuations which are now heavily discounted. Dark clouds are casting a shadow over the economy at present, but clearer skies are potentially on the horizon."


Peak inflation narrative

One possible bright spot is the sign that although prices will continue to rise, the pace of increases may start to fall gradually. Many commodities, including crude oil, have become cheaper and supply chains are recovering from COVID. Although central banks have not yet acknowledged weakness in the global economy – helped by continued strong employment data – there is a credible scenario where markets will soon start to anticipate this.

"European prices will likely continue to rise in the near-term but elsewhere a narrative could be building that the rate of change of inflation is peaking, particularly given the high base effects in CPI and PPI," Edholm explains, "Markets, which move 6-9 months ahead of actual fundamentals changing, could soon start to factor in a more benign environment with central banks retreating, which would mark the inception of a new investment cycle, led by early cyclical companies."


Wider and deeper pockets of value

August's losses mean that the MSCI All Country World Index of global equities is now down 7.0% in 2022[2]. This has reduced the price tags of most stocks, particularly in the US where the S&P 500 index of blue-chip companies has fallen 17.5% and the tech-heavy Nasdaq Composite is 25.3% lower than the start of the year.

While valuations are still close to historic averages, the correction has created new buying opportunities, as Edholm outlines: "The investment universe for price-driven investors has really opened-up. Technology companies and those with high quality brands in sectors like consumer goods and clothing that were previously very expensive are now investable with 50% upside over a two-to-three-year investment horizon."

Even greater value can be found in less popular areas of the stock market like emerging markets, particularly in countries like Korea and Mexico, and industrial metals such as copper where short-term demand has fallen but which remain crucial to the longer-term green transition.

Making the most of these opportunities requires taking a contrarian approach. It is harder to think independently when stocks are falling as the herd mentality of investors grows stronger but the returns are often greatest, as Edholm explains: "Markets are increasingly driven by machines using passive, factor and momentum-based strategies and this creates very interesting and lucrative opportunities for investors who are willing to go against the tide." 

For value-driven and contrarian investors like SKAGEN, the possibilities to create value for our unitholders are growing. Until the inflationary picture clears, stocks will likely remain volatile but also attractive relative to alternative assets – while the ride will be bumpy, the rewards could be great.

[1] Source: MSCI: MSCI All Country World Index in EUR as at 31/08/2022
[2] Source: MSCI: MSCI All Country World Index in EUR as at 31/08/2022

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