Stocks soared last week after inflation in the US came in lower than expected.
We decided to buy back into stocks – specifically, European banks and Energy companies – because of three major developments last week:
1. The US inflation surprise on Thursday reduced the risk of US interest rates going up too high, too fast.
2. On Friday, China indicated it is taking steps towards living with COVID.
3. Also on Friday, Russia withdrew from Kherson without incident. Use of unconventional weapons by the Russians has been a constant tail risk hanging over the market, but that risk now seems to have reduced.
As a result of these developments, we view the world as stable enough again that we are now happy to hold risky stocks, at least for the time being.
European banks are prime beneficiaries of improved geopolitical stability. Despite all the bad news out this year, the sector is only down 3% for the year to date. That shows great resilience and can be explained by the huge increase in interest rates, which banks benefit from.
European banks are still cheap. A good example is $BNP.PA (BNP Paribas SA), which trades at 7x forward earnings. Historically, the company has traded at 9x forward earnings, and we would argue that a 10x multiple would be justified given the improved interest rate environment. This indicates the shares have 30-40% upside. It is a similar story with the rest of the European banks in the portfolio.
These are risky companies. At the slightest hint of economic trouble, they lose 20%; a typical recession sees their values drop 50%. However, the price action of the banks this year suggests that a recession may already be in the price.
We have held an overweight in European banks for several years. It has done nothing for overall portfolio performance, which has been more driven by choosing superior banks within the sector. We continue to have a strong conviction that the banks will perform well over the coming years, as the interest rate environment has changed, and have to be worried about missing the future upside, too. A portfolio full of banks is not comfortable to hold given the upcoming 2023 European recession, but our general approach is to accept risks when the economy feels stable enough.
We have also opened positions in a few oil companies, which we believe are undervalued like the banks. We expect the oil price to hold up well next year due to low inventories, tight supply and the Chinese reopening.
The portfolio is now almost 100% invested in European banks and Energy companies.