The long shadow of the war

The global economy and the corporate sector are currently being hit by a long list of problems: the ongoing pandemic, fragile value chains, high inflation rates, monetary tightening, and the war in Ukraine. Taken separately, the problems are already disruptive, but in combination they create a complex and adverse environment. In this economically tense situation, it is all the more important to use a fundamental approach to select those companies that are likely to emerge from the crisis in a stronger position.

The recovery from the pandemic has been interrupted and/or curbed by the war in Ukraine. According to current assessments by the International Monetary Fund (IMF), the global economy continues to show positive growth, but its speed has slowed down significantly. Due to Europe’s high level of dependency, the war is having a particular impact on the continent’s energy and commodity costs. In addition, China’s current zero Covid-19 strategy is resulting in renewed dislocations in the value chains. The European and US central banks are under pressure to tighten their monetary stance significantly, among other things by raising interest rates, as we are currently seeing in the US. In light of this, the equity markets may be seen as losers, but is that really the case?

This volatile phase has favoured defensive sectors (“safe havens”) and commodity companies, as well as oil and gas companies. Nevertheless, caution is advised, as the valuations of the defensive companies have already risen significantly. Moreover, it is unclear to what extent commodity, as well as energy producers, will suffer from swing producers and from a weakening macroeconomic environment. In our view, the second tier of profiteers is much more interesting, i.e. cyclicals with pricing power and small and mid-cap niche specialists. They trade at a low level compared to the overall market and, despite an inflationary environment, they can increase or protect their turnover and profits through price increases.

This pricing and profit framework results from different qualitative and quantitative factors. In the first place, the factors include the general pricing power, due to high market share and the ability to enforce these by means of price increases. Second, input costs are important, i.e. raw material and energy costs, as well as the degree of processing automation. And finally, how dynamically can costs be controlled in order to protect margins? Often underestimated here is the established cost culture. Companies that define continuous improvement of cost efficiency as a goal come out of a crisis much stronger.

The current war in Ukraine will also lead to some structural changes. Inflation rates will be structurally higher than in the past decade, which was characterised by low volatility and global cost optimisation. Based on their experiences from the pandemic, companies have already started to diversify their value chains by relocating operations to neighbouring or nearby regions. A more diversified supplier base is another aspect that is driving up inflation. These changes are usually accompanied by higher production costs, which ultimately need to be borne by the end consumer. A new inflationary component, particularly in industrialised countries, is the shortage of skilled workers.

This ranges from truck drivers to IT experts, and leads to stronger wage increases than in the past. Overarching geopolitical tensions, particularly with Russia, are causing further strains. The system is changing from global, cost-efficient, “just-in-time” value chains to “just-in-case”. In the latter, the reliability and resilience of the value chain has priority.

Companies that operate globally and tap into new markets are much better equipped to deal with adversity. In addition, a large number of small and mid-cap enterprises (SMEs) are owner or family-run and have robust balance sheets. They were able to use this advantage during the pandemic and continue to invest in products and services, so that they ultimately came out of the crisis stronger.

In contrast to the pandemic, the sanctions against Russia will remain in place over the long term, even if the war in Ukraine hopefully ends soon. This will have implications for companies and for society, as we are already seeing in the value chains. Despite the short-term volatile phase of the global economy, we do not expect a significant recession unless the war spreads. The current share price valuation of cyclicals and SMEs allows for similar investment opportunities to those at the beginning of the pandemic. A large number of SMEs are trading at significant valuation discounts in an undiversified sell-off and this offers the opportunity to acquire high-quality companies for an attractive price.