James Gard: There's already so much going on with geopolitics and markets at the beginning of the year. Luckily, I have with me Michael Field, who is going to explain what's really going on.
Last time we spoke, Michael, markets were already pivoting towards the idea of rate cuts, and there was a feeling of exuberance. That just seems to have vanished within a matter of weeks. So, what's really going on?
Michael Field: I think the market rally that we saw in December, as strong as it was, and it contributed heavily to the returns that investors got last year, was pretty fickle in origin. It was very much sentiments driven. So, people saw this upside of interest rate cuts, and they got slightly ahead of themselves towards the end of the year. And a lot of people thought this might carry over then into 2024, but suddenly that kind of enthusiasm has faded. And that's what happens when you have rallies based on non-fundamental things. They're quite fickle and they fade off again, and that's the current situation we find ourselves in now.
Gard: Sure. It seems a bit early to write off the markets. I had a commentary this week saying, hopes of a better year for the FTSE 100 are diminishing already. I'm thinking it's a bit early in the year to start trying to – I mean, we're in the market of making predictions, but it's a bit early. It's only kind of two weeks in the trading. I read a piece that you've written, and you were saying that investors are just going to have to be patient in terms of sustained returns. And if there isn't a huge rally in January, it doesn't matter a huge amount.
Field: I think that's fair. Yeah, the message hasn't really changed from that perspective. Ultimately, you're investing, and you should be investing based on fundamentals. Now, for the market itself, we think the market is kind of roughly fairly valued. But within that, there's various sectors and subsectors that are really undervalued that have a lot of opportunities at the moment. So, if you want to be long-term in that perspective, you really have to get it dig in deep, find those sectors that are undervalued and then invest and not expect a swift return on your capital, but expect that over time, that story will play out and ultimately, you'll get the reward for your work.
Gard: Sure. In terms of geopolitical risk, one thing I hadn't seen coming at the end of last year was the issues in the Red Sea and the shipping disruption, and even today, rockets fired between Pakistan and Iran. I mean, it seems to be that investors have a new thing to worry about every month. This is just normal now, isn't it, for the markets?
Field: We've had periods in history where there's been a lot happening. And I think we were just lucky in that we probably had a 10, 12-year period thereafter the financial crisis when the geopolitical crises that we faced were kind of fewer in number. And now suddenly, we've been hit with a lot since the pandemic, the Ukraine war, the Red Sea issues now that we're facing. The difference really is how many of them have a real material impact immediately on markets is the other question, right? When the whole Israel war kicked off a couple of months ago now, we did some analysis on how many stocks were affected. And in the scheme of things, if that conflict stays isolated to that region, there's little impact on Western markets. But as you said, the more things happen, the Red Sea crisis, if other things like Iran and Iraq and things like this start flaring up again, obviously, that has a much bigger global effect. We've spoken about defence stocks as well and the structural growth story there. So certainly, there's knock-on impacts, but it's important to look at these things one at a time and really assess how much material impact each of them have, I think.
Gard: Sure. They may have a cumulative effect at some point where the markets say, look, we're taking geopolitical risks seriously. But with every crisis, there seems to be an immediate reaction and then return to normality. Another story that perked up since we last spoke is inflation. And I wasn't hugely surprised to see U.K. inflation back up this week. I read headlines today about inflation shock. The U.S. has seen it, the Eurozone has seen it, and now the U.K. has seen it. How do market participants change their view of this year based on where they think rates are going and inflation sticking around?
Field: So, I think the first thing is to put it in context, right? The U.K. had 11 months of declining inflation and inflation fell from 10% to 4% basically, which in the scheme of things is a great result. I think we all would have taken that at the beginning of the year. I think the shock, if you will, as you put it, to markets is that it didn't decline in December. It actually went up 10 basis points, which, yes, it's disappointing if you'd expected that straight line decline. But in the scheme of things, does it change the picture? Not massively.
Ultimately, our view of inflation is like this. Inflation has come down an awful lot, which is great for markets and should help certain sectors of the economy at least this year. And it should help consumers, right? Their belts have been tightening for a while and this should take some of the pressure off. But at the same time, inflation is still twice the level of the Bank of England or the ECB's targeted rate. So, from that perspective, there's a lot more to go. So, it's not mission accomplished yet. It doesn't mean immediate rate cuts either. So, there's a bit to factor in, but certainly we've had a lot of progress in inflation. That shouldn't be dismissed.
Gard: Sure. Yeah. If you look at the trend line, it's been a big lurch downwards and a little tick up rather than a big reversal. Just sticking with the theme of the consumer, I mean, earning season already kicked off in the U.S. and it's about to in Europe. You think that consumer-facing companies are going to have a tough time. I've already noticed three profit warnings so far in the U.K., at least – Burberry, which is luxury exposure; Crest Nicholson, housing market; and PageGroup, which is recruitment. So, they're all different sectors, but they all have an overarching consumer link. You fear for consumer-facing companies in this coming earnings season.
Field: To some degree. It's the sector that we're saying that you should expect differing results. Some of the companies are still managing to fend off inflation and pass through price increases, and some of them are struggling at this stage. They've been passing through maybe double-digit price increases for two years now to consumers. And a lot of consumers are simply that stretched that they can't afford anymore.
I think the three companies that you said, yeah, you're right, they all differ in terms of the industries that they are involved in, but they have one common link, that they're all at the cold face, be it a luxury goods firm that's dealing with end consumers, be it a recruitment company, which we all know are highly cyclical, or a house builder also, they're very much at the cold face, they're very much seeing the impacts of high interest rates and high inflation to some degree up to now as well. So, I think what consumers – or what the investors rather are maybe missing is that yes, the picture looks brighter in terms of interest rates coming down from here, but the fact that interest rates have been really high for a little while now means that that still has to feed through, and that can mean more pain for the next, call it, six months before we see any kind of upside again.
Gard: Sure, that's interesting. This is my favourite earnings season because it covers a whole year period for a lot of companies. So, you get a better picture than say Q3 earnings. But as you say, what investors really want to know is forward-looking stuff. They don't necessarily want to know what you did last year. They want to say – you want them to say, look, things are getting better. But you're kind of suggesting that investors need to just wait a bit for inflation falls to pass through, consumers to feel a bit better, and it's a gradual process rather than immediate one.
Field: I think that's a pretty good conclusion, yeah. And if you look, as you said, it's forward-looking. And for a lot of these companies, the visibility is relatively low. They can only tell you what they're seeing perhaps over the last few weeks. Recruitment companies generally, I know, having covered these, their forward visibility is a maximum of about six weeks. So yes, it's interesting. Yes, it's good to take it into account. But if you're a long-term investor, you really need to have your own view and supplement that with what the companies are seeing right now, rather than just take exactly what they say and extrapolate that into the future.
Gard: Sure. Yeah. Burberry is an interesting case of that because it was quite a significant profit downgrade. I don't necessarily want to talk about Burberry in detail. But do you expect earning seasons to be full of those nasty surprises for investors? And the last earnings season, we had some big share price falls. So, are investors better prepared for nasty surprises? Or is it going to be like 10%, 20% share price falls on the day sort of thing?
Field: I think you could see a little bit of that. I think, yes, investors should be prepped for more surprises. But at the same time, it's difficult to know exactly what to expect. And there's so many moving parts, right? So, you've got some companies benefiting from falling inflation. Some of them will be able to hang on to those price increases while benefiting from lower cost bases, which then you could see profits rise for some industries. And some are really going to struggle to pass on those increases. And then others are paying really high debt payments. And perhaps they've had to refinance towards late last year or something like this too. So, it's going to be very mixed. And I think investors won't know exactly what to expect from each company. So certainly, on the day, you should expect some surprises. I won't be surprised if we see some reasonably large share price moves as investors struggle to adapt immediately to the new conditions for these companies.
Gard: Sure. Yeah. I mean, it makes for good copy for journalists necessarily, but it's an unpleasant experience for investors. You mentioned debt there. That's quite an interesting element to it. Because I remember going into COVID, the heavily indebted companies were seen as pariahs and they spent ages trying to clear up their balance sheets, rights issues, all that sort of thing. Do you think companies are now more in better shape, more resilient financially? I mean, their borrowing costs haven't really budged. I mean, they're still really high, right?
Field: Okay, there's a big difference here as well between – and this is why valuation has moved for maybe large cap stocks and there's a bit of a gap between them and mid cap and small cap stocks. Because a lot of the large cap stocks have very strong access to capital markets, both in equity perspective, but also debt markets that I've seen some companies that I've covered issue debt in the last year at government levels or even slightly below government bond yields. So, they haven't really budged and a lot of them have staggered their debt over a number of years. So, their actual financing costs aren't huge, but a lot of the smaller and mid-sized companies haven't had that luxury and have had to refinance as and when they needed it in maybe a less organized fashion. And then suddenly, they might be dealing with higher debt costs for a year or two before that smooths out again. So, it could make a great deal of difference for some of those small or mid cap companies rather than the large cap companies, perhaps.
Gard: Sure. That's interesting. A completely different profile of debt there. But I guess they'll be looking for interest rate cuts more than most, but they might have to wait a bit longer for that. If you don't mind, we go on to sectors as a last bit of our conversation really. Just looking at your most recent note on what you think of undervalued, say, utilities, healthcare, consumer defensive and communication services, that's quite a wide range of companies, but which sectors are you particularly keen on for this year?
Field: Yeah. Well, I think, first of all, it's good to have so many opportunities that are undervalued still, even though markets are fairly valued, which is an interesting one. I think even just picking a couple of them, so consumer defensives, I'm as surprised as anyone that it's trading at a pretty good discount to where it's supposed to be. A lot of these companies have structural growth stories, they're very defensive over the longer term. Some of them are struggling now a little bit after two years of really high inflation, but longer term, they tell a very good story. And then within that, you've got names like Anheuser-Busch, one of the, if not the largest alcohol beer manufacturer in the world that's trading at a pretty sizable discount currently. Investors just aren't 100% sure that there's a volume growth, that consumers are cash strapped, et cetera. Then things like Nestlé as well, the kind of flip side of that but in terms of other consumer goods, again, trading at a discount to where we think it is, and a pretty rare discount at that as well. So, there's some opportunities in real household names that you might not have thought there would be.
And then perhaps the other one is then in healthcare. It's really bifurcated. So, there's a big investor focus on the obesity drugs. You had all that fanfare last year about obesity drugs and the impact that would have on the industry, and maybe on other industries like snacks and things like this as well. But there's other industries within that as well, within the healthcare that have been overlooked. So, we think second generation beneficiaries of these obesity drugs, like Roche and Pfizer are materially undervalued. And then some of the names that were heavily involved in the COVID vaccine, like Moderna, for instance. Again, these names have been overlooked by investors who have somewhat lazily bracketed them as a specific segment related to only COVID and are ignoring the bigger pipelines that many of these companies have.
Gard: Sure. Brilliant. Well, thanks for that summary. Let's catch up next month and we can pour over our earnings season to see the winners and the losers. So, thanks so much for your time, Michael. For Morningstar, I'm James Gard.
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