Relative Value in Sweden, and What NOT to Do Right Now

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IN THIS PUBLICATION:

• Relative trade: Sweden has the highest 10-year growth profile of any major European country, is hedged from the key risk in Europe (energy supply), and is trading at the lowest valuation premium to European markets over the last 20 years.

• The US equity market has traded rangebound for almost one year, and it could continue to do so for quite a while.

• This is easily the most challenging period to have a confident macro forecast in the last 50 years. We highlight what NOT to do right now.

Where to Look in Europe

Before we get in, let me be clear about one thing: I think the rally in European stocks has gone too far, and there’s little incentive in overweighting right now. The Ukrainian counter-offensive, whilst delayed, is still likely ahead of us (more on that next week on Lykeion Research), we’re closer to seeing a pause followed by a pivot in the US (looser financial conditions), and whilst I don’t think that energy will be a problem during most of summer, we should see winter-time energy demand worries from August onwards (bad for volatility).

As we wrote to our research subscribers in March, the future prospects of stock market returns, in general, are quite bleak after a decade-plus of the largest asset bubble in history. In a market that trades sideways, to generate returns, we need to be able to implement relative trades.

Europe versus the US is one of the most common relative trades pitched by analysts. As per Verdad: “Europe generally is cheap. Today, Europe’s CAPE ratio is 20.4x versus 28.2x in the US, according to data from Barclays. This means Europe’s CAPE valuation today is 28% below the US, a discount that is nearly double the 15% historical average discount since 1981”.

As you know, I’m a big fan of Verdad’s work, but the “historical average” benchmark is a bit misleading here simply because since the 1980s so much has changed in the workings of Europe that I don’t think it’s reasonable to look at those 40 years, plot a simple average, and indirectly hint towards mean-reversion.

In fact, after the current rally in Europe, the valuation discount to the US is pretty much in line with that of the last decade-plus (i.e. in line with the post-EU debt crisis discount, which I think better reflects the current reality of Europe), and that is despite (1) a war on the continent (2) the upcoming energy supply volatility in Q3 and Q4 (3) recurrent social unrests in many key countries, with special mention to France who, in theory, was supposed to lead Europe in a post-Brexit post-Merkel world, but is instead seeing protesters storm the Paris offices of BlackRock with flares. Go figure.

So, whilst I’m not truly enthusiastic about Europe, in a relative trade world that’s potentially a good thing. Enter Sweden.

As per Verdad [emphasis added]:

• “Sweden isn’t the cheapest market within Europe. Sweden’s CAPE ratio of 20.1x today is slightly below the European market at a 2% discount. But Sweden usually trades at a significant premium to the broader European market.

• Sweden has a highly skilled workforce, a stable political environment, and a business-friendly regulatory framework, as well as a number of market-leading global companies like Volvo (which today trades at 8x EBITDA), Ericsson (which trades at 5x EBITDA), and H&M (which trades 11x EV/EBITDA).

• Sweden is also the original home of IKEA (which is privately traded), and the country remains a core element of the company’s brand. In the table below, we present a valuation spread analysis where CAPE ratios for each major European country are measured relative to the 20.4x CAPE ratio of the overall European market. The table is ranked by valuation percentile relative to recorded history since 1981.

• In light of the geopolitical events of 2022, we think it’s relatively obvious why Poland and Germany are trading at a discount to the European market, given Poland’s proximity to the conflict in Ukraine and Germany’s unprecedented recalibration of energy supplies.

• But none of those arguments apply to Sweden, which is located in northern Europe and generates 91% of its electricity from nuclear, hydro, and wind power. Instead, the uncertainty in Sweden appears to stem from unique imbalances in its housing market, where roughly 71% of new mortgages are issued with floating interest rates (for context, only about 14% of new mortgages in Germany are issued with floating rates).

• The uniquely high sensitivity of Swedish households to rising interest rates has economists concerned that a decline in household spending could tip Sweden into recession this year, with a 0.8% expected contraction of GDP in 2023, making Sweden the only country in the 27-member European Union likely to see negative GDP growth for the full year, according to the European Commission.

• But we think these uncertainties are already priced in, and we believe investors will be compensated for bearing these uncertainties over the long term.”

Sweden has, amongst major European countries, the highest 10-year forward growth profile, it’s hedged from the key risk in Europe right now (energy supply), but trades at the lowest premium in more than 20 years. Seems like a good starting point for a relative trade, if you ask me.

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It’s All Beta

The big story so far this year has been highlighted in last month’s Update: “The most important market event in Q1 was the pricing of a more dovish Fed going forward. This means the market is chasing long-duration assets (Bitcoin, tech, bonds) as it believes the Fed will soon begin cutting rates. This is a very different market set-up compared to the majority of last year, and more in line with 2020 (post-COVID) and 2008-2019”. Since last month, very little has changed, but here are some key things to consider:

• Inflation in the US is now at a 2-year low, and for the first time in a while, we have Fed funds higher than inflation, something that has rarely happened over the last two decades (and an important marketing milestone that gives the Fed more room to pause).

• Investors expect the recent hike to have been the last, with cuts starting in September. As Charlie Bilello wrote in his weekly update, “this would be a relatively quick shift to easing after only 4 months at a peak cycle rate”, compared with an average of 10 months at peak rate during the last three cycles. But hey, given that we’ve just gone through the fastest repricing of rates in US history, is it unreasonable for the market to be repricing rates lower at such a fast pace as well?

• Obviously, this dovish reset has allowed risk assets to perform well. The vast majority of the rebound this year in the US has come from large tech (i.e. high quality, mega-cap tech companies like the FAAMG). In fact, Apple’s stock market capitalization is now larger than the whole stock market in Germany.

• Europe has also performed very well (probably too well as we’ve outlined above) despite the lack of high-growth tech companies, but this doesn’t seem to worry Bernard Arnault too much.

• There was a moment earlier this year (in January) where even lower quality and unprofitable tech (think SPACs) was outperforming, but the market seems to have learned its lesson.

• The concentration of returns in large tech is best exemplified by the AD line breakout earlier this year (as per Investopedia, “The advance/decline line (or A/D line) is a technical indicator that plots the difference between the number of advancing and declining stocks on a daily basis. The indicator is cumulative, with a positive number being added to the prior number, or if the number is negative it is subtracted from the prior number”). Usually, when the S&P 500 is rallying and the A/D line is falling, it shows that fewer stocks are participating in the rally, and this could “potentially” mean that the index is nearing the end of its rally.

• One theory for this outcome is that investors are parking their money in high-quality assets, with solid balance sheets, faster revenue growth, and higher margins.

• More likely though is that the concentrated run-up has mostly been driven by buybacks as mega-caps in tech have the balance sheets to implement these schemes. In fact, buybacks are running close to the highest levels in a decade.

• This means that institutional investors have probably missed part of the rally as they’ve been hedging their books in anticipation of the most widely expected recession in history.

• General risk on sentiment around tech has also been fueled by a better-than-expected earnings season and the prevalence of AI headlines around news outlets and Twitter feeds.

• Elsewhere, gold and gold miners have also outperformed so far this year –again driven by expectations of lower rates going forward (gold is negatively correlated with real rates).

• Energy has been the big underperformer so far after last year’s victory lap – in fact, the only sub-sector doing worse is US regional banks, for obvious reasons.

• The key reason for this energy underperformance is that investors don’t want to touch most cyclical commodities ahead of a recession (where usually demand falters, which negatively affects the price of commodities). But the IEA seems to kindly disagree…

What do we make of all of this?

• After last year’s bear market, we’ve rebounded and are now stuck in a range (currently flirting with the top end), waiting for a narrative that leads to a breakout higher or lower. That doesn’t necessarily mean we need the breakout to occur imminently – we can trade range bound for as long as it’s necessary.

• In fact, after the inflation peak post-WWII, we were stuck in a trading range for two years between 1946 and 1948 (we’re less than one year in).

• What’s interesting currently is that even if you identify the right narrative (pivot, recession, higher unemployment, US debt-ceiling risk-off event, whatever makes you tick), and time it correctly, actually making money from it isn’t that straightforward.

• That’s because we live in a world where bad macro news might mean lower equity prices (valuation multiples contract and earnings revisions) or higher equity prices (expectations of central banks easing drives multiples and earnings revisions higher).

• This is why we have such a large cohort of people using the same data sets yet deriving different but still very valid conclusions.

As Jacob and Roger highlighted in early January, and as Stan Druckenmiller reminded us in his latest Sohn 2023 conference interview, this is easily the most challenging period to have a confident macro forecast in the last 40-50 years.

Said another way, this is no time to be a hero. There will be plenty of great investment opportunities (what Druckenmiller calls “fat pitches”) over the next couple of years (especially for active investors, should the market continue to trade range-bound), and to profit from those, you need to be able to stay liquid and well capitalized.

What this means is that you should probably:

• Keep your gross exposure low. You want to have the liquidity to capitalize when fat pitches cross your inbox.

• Go gentle into that pivot. As Morgan Stanley’s Andrew Sheets highlighted: “Current data looks worse than prior “good pauses” that boosted risky assets. It’s not just inflation. Relative to the bullish pauses of 1985, 1995, 1997, 2006 and 2018:

 1. Current Industrial Production (IP) is much weaker

 2. Leading indicators are negative (they were positive during ‘good pauses’)

 3. The yield curve is inverted (it was positively sloped during ‘good pauses’)

 4. The labor market is tighter

 5. Banks are tightening credit conditions significantly (versus easing, or neutral conditions during ‘good pauses’)."

• Or as Goldman’s Bobby Molavi wrote: "...new job openings are the lowest they’ve been since Apr 2021, with layoffs the highest they’ve been since Dec 2020. We’re starting to see leading indicators of repricing of credit like subprime auto loans falling to around 2% of all auto loans from around 10% in 2018. We saw German industrial production fell more than expectations in March on the back of weakness in the Auto sector. Oil has had its 6th monthly loss in a row. US courts have just seen 57 ‘large’ insolvencies in Q1 for the busiest quarter since 2009".

• The risk of downside is real when we’re sitting at the top of the range, especially when you consider that higher rates impact the economy with a 12-month lag and we’re only starting to feel that now.

• Avoid chasing non-profitable companies that will require significant amounts of investment over the coming years. ChatGPT and AI in general are revolutionary, no argument there. But as frequently happens every time new technologies that could potentially disrupt our way of living pop up, we tend to be carried away too fast, and that’s no bueno for our investment portfolios. Don’t buy fads.

• Hedge yourself ahead of the debt ceiling negotiations that are sitting ahead of us. There is no way the debt ceiling won’t be increased, but the path toward agreement can potentially be messy given how political the debate has become, and that could have a significant short-term impact on volatility. Good pod about this here, and Roger will be giving some hedging options in our Research report next week.

Sometimes, knowing what not to do is more important than knowing what to do.

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Thanks for reading through! Obviously, none of this is investment advice.

As always, we'll see you out there...