Patrick Suck, Portfolio Manager of the ODOD BHF Polaris Flexible
Last year, the sharp rise in inflation dominated developments on the capital markets. In view of the rapid rise in interest rates on both sides of the Atlantic, the valuations of growth stocks, where profits are only expected in the future, came under pressure. By contrast, value stocks with stable earnings were in demand. In the meantime, falling energy prices and higher interest rates have helped to ease the situation on the inflation front. We expect inflation in the euro zone to remain high on average for the year, but it could fall to 3 to 4 percent by the end of the year. This would mean that inflation has seen its peak in October with an inflation rate of 10 to 6 percent. After last year's inflation shock, 2023 could become the year of disinflation, with inflation rates still high but falling.
What impact would this trend have on investments? Which asset classes and sectors might benefit, and which might not? In principle, a disinflationary environment is more favorable for the quality stocks we favor than a rising inflation environment. Oil and commodity stocks benefit from an inflationary environment, and thanks to rising interest rates financials. These are sectors with companies that are less likely to be selected for a portfolio based on their quality. Portfolios focused on quality stocks therefore lag in inflationary phases, even if the long-term outlook for these companies remains stable.
The fact that interest rates must rise to fight inflation also puts pressure on equity valuations. This weighs particularly heavily on growth stocks, which are valued based on earnings far in the future. To a lesser extent, however, quality stocks are also affected, while value stocks benefit. A disinflationary environment would therefore support valuations of quality stocks. Many companies can pass on rising input costs and even increase their profit margins despite inflation. This was also the case in 2021 and 2022, when margins for European and US indices rose to new highs. Cyclical sectors such as oil/commodities, automotive and industrials benefited most from this. As margins fall due to disinflation, these sectors come under greater pressure, while margins for quality stocks tend to remain more stable. According to our analysis, this makes them more attractive in comparison.
Because rising key interest rates slow growth, disinflation is usually associated with weaker economic growth and an increased likelihood of recession. As yet, this is only beginning to be seen, especially in the USA, but it could become an issue in the course of the year. Even in the event of a recession, we believe that quality stocks are better positioned, as experience has shown that the earnings of these companies are more stable and exhibit resilience even in downturn phases.
In the portfolios of the ODDO BHF Polaris funds, we are continuing the strategy of sectoral and regional diversification of the portfolios that we started last year. The focus remains on quality factors such as higher return on equity, higher EBIT margins, lower debt, and more stable earnings growth. With companies from sectors such as health care, software and consumer staples, the portfolio includes a number of stocks which, in our analysis, could benefit from a possible trend towards disinflation.
