July 2023 Review

"Tech stocks continued to dominate, but the rally's breadth increased in July, although for a change US equities lagged modestly Europe"

By Portfolio Advisor Paul Sedgwick

Dear Partner

Renewed confidence that the US economy will avoid a technical recession, a results season no worse than expected, inflation rates falling faster than forecast, and hopes that interest rates are peaking around the globe boosted equity prices in the past month. Tech stocks continued to dominate, but the rally's breadth increased in July, although for a change US equities lagged modestly Europe and the Emerging Markets. As well as equities, the "riskier" part of the bond market had a better month, adding to the more positive sentiment. The UK gilt market, at the shorter maturities, took a modest boost from the improving inflation picture.

US treasuries hardly moved in July, as markets had generally discounted the Federal Reserve 25-basis point rise. Oil had a better month as Saudi's production cuts took some effect and in response to the resilience of the global economy, which saw the IMF modestly improve their outlook, as a result, Brent crude rose almost 15% on the month. On the negative side, the flash Purchasing Manager Surveys for July indicate that the leading global economies of the world are slowing, and the boost the US economy has had from excess saving is running out. The bond market remains more sceptical of the economic outlook than the stock market. The Communication services sector, which includes the likes of Alphabet and Apple, was the big winner in July, along with oil and materials. The laggards were once again staples and healthcare.

Portfolio

We had encouraging reports from several of our holdings, including one of our newest, Alphabet, and some of our cornerstone investments, Hermes. Overall, it's fair to say earnings season for our portfolio has reflected the defensive nature of many of our holdings. Our July gilts matured, and we continue to diversify away from the very short end to lock in these interest rates we currently enjoy for longer.

Some of the best-performing stocks in the portfolio this month were: PayPal, helped by news it developed a partnership with Microsoft for pay later services, and the company benefitted from a more robust US economy based on June macro-economic data, along with its ongoing share buyback program. The shares did give up some of those gains as the company continue to see some pressure on margins.

Alphabet Q2 2023 revenues were $74.6bn, +9% (constant currency), which beat estimates by 2.5%. Diluted EPS was +19% due to growth in cloud services and focus on cost discipline. Sundar Pichai, CEO of Alphabet and Google, said: "There's exciting momentum across our products and the company, which drove strong results this quarter. Our continued leadership in AI and our excellence in engineering and innovation drive the next evolution of Search and improve all our services. With fifteen products serving half a billion people and six serving over two billion each, we have many opportunities to deliver on our mission."

Burberry recovered some of the weakness after its full year results in May. In July, Burberry’s Q1 results management reported an 18% rise in quarterly comparable store sales, meeting market expectations thanks to a continued rebound in China. Sales in Mainland China were up 46%, while sales in Europe rose 17%. Management also announced there are foreign exchange headwinds of c.£150m to full year revenue and c.£70m to adjusted operating profit.

Underperformers were Estee Lauder as the share price continues to suffer following the lower-than forecast results on slower sales in Asia. Earnings for the next fiscal quarter are due on the 17th of August. Smith & Nephew had its share price target lowered by Credit Suisse analysts early in the month; although the results haven't been posted yet, J&J's results did suggest an increase in demand for Smith & Nephew products. Merck announced an expected loss in the quarter, due to its new acquisition of Prometheus, however, it did beat analyst's forecasts at the headline level. Analysts at Credit Suisse highlighted Merck as one of their favourite names in pharma due to its crucial drug franchises. The share price suffered a little in July from the move in investor sentiment away from healthcare.

We added Lockheed Martin during the month given it is well positioned in US defence spending and for international defence contracts, it has a strong balance sheet and cash generation, and provides a dividend yield of 2.8%. The company has raised its dividend for the last 20 consecutive years and has carried out share buybacks of 20% of the company’s shares over the last 10 years. The share price was 6% lower than at the start of the year due to supply constraints and offered an attractive entry point for us. Q2 earnings beat expectations by 5.0% to $16.7bn (up 8% year-on-year), and EPS by 4.4% to $1.7bn. Management reported a record order backlog of $158bn. Free cash flow in Q1 was $1.6bn, and Q2 was $1.1bn. Lockheed returned $1.5bn to shareholders through dividends and share repurchases in Q2, following $1.3bn in Q1.

Other notable portfolio companies reporting in July included:

• Hermes posted strong H1 earnings with sales increase of 27.5% to EUR 3.3bn and 44% EBIT margin in H1 23, while peers LVMH and Richemont missed analyst estimates.

• Johnson & Johnson forecast 2023 profit above Wall Street estimates, based on strong demand for its cancer drugs and a recovery in sales of its medical devices due to an uptick in surgical procedures such as hip and knee replacements. J&J posted better-than-expected Q2 earnings of $2.80 per share, compared with analysts' expectations of $2.62. J&J also continued its spin-off of its consumer health unit. Johnson and Johnson’s share price did suffer a little on ongoing concerns over litigation in its talc division.

• Sanofi reported Q2 sales below consensus at EUR 9.97bn, below estimates of EUR 10.21bn. Sanofi hiked its 2023 earnings per share guidance but also increased the FX headwinds. Sanofi also announced it will acquire ownership of Qunol. Overall, the mix was received well by the market.

• Procter & Gamble exceeded earnings and revenue estimates for its fiscal 2023 fourth quarter with the help of higher prices. CEO Jon Moeller said the solid results came despite the company's facing “significant cost headwinds.” He added that P&G anticipates that it will be dealing with “continued macroeconomic and geopolitical challenges” in the new fiscal year

• Colgate-Palmolive reported earnings per share was +7.5% y-o-y and revenue of $4.82bn (+7.7% y-o-y), both above estimates. Total volumes declined 3% on an organic basis, while pricing was up 11%.

• Nestle organic sales during the period rose 8.7%, beating the average estimate for 8.1% growth. Nestle's underlying trading operating profit margin was 17.1%, an increase of 30 basis points on a constant currency basis. Underlying earnings per share increased by 11.1% in constant currency. Nestle improved its full-year organic sales outlook

• IMI plc confirmed its full-year adjusted EPS guidance, which is in line with consensus, and reported an increase of 17% in adjusted profit before tax. IMI said it expects a 1% hit to full year results as foreign exchange has become less favourable since it first set profit targets.

• Shell Q2 profit reduced 56%, Q2 adjusted earnings of $5.1bn and missed estimates of $5.8bn. Lower results mainly reflect the drop in LNG trading results, oil and gas prices, refining margins and sales volumes. Shell remains committed to the share buyback program despite a slowdown. The results compared with record quarterly earnings of $11.5bn a year earlier and $9.65bn in the first quarter of 2023.

• Microsoft Q2 revenue was $56.2bn and increased 8% (up 10% in constant currency). Diluted earnings per share was $2.69 and increased 21% (up 23% in constant currency). EPS beat estimates by 5.5%, and Revenue beat estimates by 1.3%. Growth in cloud services slowing growth rate impacted investor sentiment but grew 21% to $30.3bn. “Organizations are asking not only how – but how fast – they can apply this next generation of AI to address the biggest opportunities and challenges they face – safely and responsibly,” said Satya Nadella, chairman and chief executive officer of Microsoft.

• Coca-Cola Q2 Revenue was $12.0bn, +6% y-o-y. Organic revenues were +11%, volumes +1%, price/mix +10% in the last quarter. Earnings per share was +34% to $0.59. Coca-Cola raised annual forecasts as demand was unaffected by price increases.

• Texas Instruments Q2 revenue was $4.5bn, +3% sequentially and -13% y-o-y. Revenue beat estimates by 3.7%. Earnings per share was $1.87, -24% y-o-y, but was above estimates by 6.1%. Next quarter guidance is slightly below estimates due to weakness across end markets with the exception of automotive. Weaker China demand and order cancellations remain elevated. Haviv Ilan, President and CEO, "Our cash flow from operations of $7.4 billion for the trailing 12 months again underscored the strength of our business model, the quality of our product portfolio and the benefit of 300-mm production. Free cash flow for the same period was $3.2 billion and 17% of revenue. Over the past 12 months we invested $3.6 billion in R&D and SG&A, invested $4.2 billion in capital expenditures and returned $6.5 billion to owners.

• Reckitt Benckiser H1 2023 Net revenue was reported at £7.4bn +8.1%, (+6.0% constant currency). Earnings per share was -8.6%. Volumes decreased as customers reduce spending due to higher prices. Reckitt raised its dividend but did not increase full year forecast from its 3%-to5% range, with management pinning this outlook caution on the ‘challenging competitive dynamics’ facing its US nutrition business in future quarters.

• Rio Tinto H1 Revenue was £26.7bn, -10% y-o-y. Profit missed estimates due to lower iron ore prices, and management cut dividend. China stimulus is expected to be a tailwind. Net cash generated from operating activities of $7.0 billion.

• British American Tobacco reported that H1 Revenue grew by 4.4% to £13.4bn (+2.6% constant currency). H1 profit from operations £5.94bn +61.4% due to comparison effect vs last year when BAT suffered a £957m impairment charge related to the transfer of its Russian business. Full year guidance remained unchanged. Increased vaping (non-combustibles) customers by 1.5m, representing 17% of revenue. Overall growth of 5.7%, while the US was -12.4% cigarette volume

• SAP cut its full-year outlook for cloud sales due to slowing demand in Q2. It reported Q2 revenue growth of 5%, in line with market expectations. Share price performance was +31% at the time of the results.

• Early in August, Diageo narrowly beat full-year earnings estimates as sales of its more expensive liquor brands offset lower volumes. Diageo's new CEO Debra Crew said in a statement: "I expect operating environment challenges to persist, with continued cost pressure and ongoing geopolitical and macroeconomic uncertainty." Diageo's organic operating profit rose 7%, beating the 6.3% expected by analysts.

Outlook 

The rise in US equity markets this year has been driven almost entirely by valuation expansion as corporate earnings have stagnated. In fact, we have had three-quarters of negative year-on-year earnings growth. The picture is improving, though, particularly if one strips out the energy sector. Valuations should rise as interest rates fall; in this instance, valuations have risen at the same time as interest rates, resulting in a collapse in the equity risk premium.

This is particularly noticeable in the tech sector, as investors have once again chased those stocks they believe have the best opportunity to benefit from the growth in Artificial Intelligence. We have commented in previous reports that sentiment was extremely bearish for most of the year and that this felt like the best prepared for bear market in history. That sentiment is changing and becoming more positive because of the better-than-expected economic outlook.

Technical analysts are also now pointing to the positive trends in US equities; for example, we have had an extended period when the US equity market has not fallen by more than 1%, and we have now had five consecutive months of positive gains. Funds are starting to flow back into equities as call options are in strong demand, and the price of options to protect one's portfolio has rarely been cheaper. The deviation of the S&P 500 from its 200-day moving average is now looking stretched. 

There is a growing consensus that interest rates in developed economies are peaking and that US interest rates could be cut at least once before the year-end. We are slightly more sceptical of when the first rate-cuts will come, particularly whilst there is an underlying resilience to the jobs market. The Fed will want to be sure that the inflation dragon is well and truly slain and will not want to start to cut too quickly, see prices rise again and be forced to reverse the decision. The global economy is set to grow between 2.5% and 3% in 2023, depending on who you ask, primarily driven by the emerging markets. Just above the 2% that economists define as a global recession. The recent Fitch downgrade of US debt from AAA to AA+ may weigh on market sentiment in the short term but is unlikely to have many long-term consequences.

The summer is traditionally a month when stocks can pull back, and as sentiment has become more optimistic fund flows more positive, the chances of a pullback cannot be ruled out. We are looking to add modestly to some of the existing names and new ideas so that any pullback would provide opportunities.

Yours sincerely

Cube Capital