Navigating Equity Markets Ahead of a Global Recession

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Murdo MacLean

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Murdo MacLean, client investment manager at Walter Scott & Partners.

So far this year, certainly equity returns have been very strong, both in global and international equity spaces. So on the face of it, although economists might be predicting potentially a slowdown or even a recession, the market to some extent doesn’t appear to be factoring that risk in. As ever, of course, I suppose equity markets are trying to look through the near term, towards the long term.

However, it does feel to some extent as if everybody is hoping that we somehow get away with this one and that corporate earnings will be not as bad as we might expect. And probably the most important thing, which is underpinning that degree of optimism is just the feeling that deflation, or the fight against inflation, is being won and that at some point, sooner rather than later, the central banks, the Fed in particular, will begin to either slow or pause rate hikes, if not indeed pivot as has become the term to maybe a loosening of monetary policy.

I think from our perspective, it feels as if there’s still a few more quarters at least to go before we understand the full extent of any potential softening macro and also indeed to see how that actually impacts companies. I mean, we do feel, given the fact that we would focus on the higher quality businesses out there, that our sort of business will be far less impacted by a macro slowdown than others. But even with those businesses, I think it’s still a little early to conclude that all is well, and that there isn’t a little bit more volatility to come.

As to what sectors or regions, countries, will provide opportunities going forward, our particular approach is that there are sectors, there are industries, there are sub-sectors out there that are exposed to very long-term structural tailwinds to their businesses. Therefore, it tends to be the case that we will find a lot of interesting companies and ideas in those sectors because you’re not having to fight against the tide there and hope that the current set of economic conditions lasts for a little while longer. Because ultimately, the trends that are powering these businesses are in some cases decades long. And so irrespective of the underlying economy, you should still see growth. These companies should still be able to tap into growth.

And so in terms of the sectors, that’s very often prevalent in sectors such as technology, whether that be software or components or semiconductors, for example. In healthcare, whether that’s pharmaceuticals or particularly companies that support and surround the drug industry. It could be also in terms of medical devices, whether that is different innovative ways to carry out a procedure using robotics or other sort of factors. Or devices that help us analyze the human body, analyze blood samples, or indeed analyzing or mapping the human gene to lead to ultimately better drug development and clinical outcomes.

Those are two very obvious ones, and I think within industrial companies, for example, there are also a lot of interesting trends going on, indeed in terms of bioprocessing, which is something that we’ve been doing quite a bit of work on of late. Automation, which continues to be a very interesting space. The cost of labour doesn’t seem to be slowing down. The availability of labour has become more difficult, I think through the pandemic, but also I just think for demographic reasons and for cultural reasons, overreliance on human labour will be a risk to companies too. So there’s lots of interesting areas which are really very long term in nature.

Talking about specific examples here, in the area of technology, we clearly view a lot of the software and cloud companies as continue to have a very long runway for growth. Clearly the likes of Microsoft continue to develop their cloud business alongside that of Alphabet. You have businesses like Adobe in the content creation software space. These companies have been driving innovation for a number of years now, clearly. But also at the same time, I think if you look at the healthcare space, businesses like Lonza are particularly interesting from Switzerland. A business that is facilitating drug development, the expansion of the drug industry through not developing their own drugs, but helping drug manufacturers or drug developers, helping them manufacture their products more efficiently.

So I think what we’re seeing in that space is something akin to what we saw in the semiconductor industry some years ago. The drug companies, the biotechnology companies can focus on the science and Lonza can assist them in the manufacturing of those drugs. Equally, businesses such as West Pharmaceutical Services, also a really interesting company. Again, an example where it’s strongly exposed to the development and growth of the healthcare industry by supplying key components into that industry in terms of components that help deliver drugs and therapies into the body. But we are not taking a direct bet on a particular drug.

And so because the strength of tailwinds in the healthcare industry are so powerful, gaining that sort of indirect exposure whereby we’re relatively agnostic to which drug company wins, is a very attractive way to play that growth. So I think that’s an interesting area, and I would say in the industrial space as well, companies such as SMC in Japan, Keyence in Japan also continue to be very attractive in terms of with China reopening again. We would expect to see a continuation of the attempt to take their economy to a more value-add economy, less reliant on sort of manufacturing industry as it used to be. And as such, we believe there will still continue to be a very strong demand for products and solutions that are provided from companies like that.

I think the other area, which is something that’s receiving a degree of coverage already, but one that we’ve been exposed to for a while now is just that of differentiated consumption. We’re in a more difficult period for the consumer, but certainly within the space of luxury, for example. The likes of Louis Vuitton, Moët Hennessy clearly stand out, even in other areas such as Hermes or Ferrari. Clearly these are also brands very much operating the top of the consumption pyramid, that despite the softening macroeconomic environment, would appear to still be very much in demand from their relatively more affluent consumer base. So I think despite the clouds on the horizon from a macro standpoint, there are a lot of really attractive long-term structural areas of opportunity, which is great news for a long-term investor.

I think any business that came into 2022 with balance sheets that were perhaps not necessarily that well capitalized, whose business model or indeed industry was surrounded by some question marks because of perhaps external disruption, ecommerce or whatever it may be. Any business like that is probably going to find the current environment that bit more difficult. If they were unable to be successful or to thrive or to generate enough cash flow and profits during a period where I think we have to look back upon and say it was relatively benign in terms of monetary policy being quite loose and accommodative, overall growth being relatively good, if a business was unable to thrive in that environment, then I think it’s almost guaranteed that we’ll find this environment more difficult.

So I think from an investor standpoint, if you are a long-term investor, it would seem to be sensible that one might stay clear of some of those industries. Just for the simple fact that transparency, cyclicality, financial fragility will likely at some point lead to volatility, if not issues to deal with.