Expecting an ‘L’ not a ‘V’ shaped recovery

After falling consistently during the past few months, the PSEi showed some signs of life in the last two weeks, triggered by several positive developments. On April 27, S&P raised the Philippines’ credit rating outlook to “positive” from “stable.” On May 10, the government announced that first quarter 2018 GDP grew by 6.8 percent. On the same day, the BSP raised interest rates by 25 basis points, helping alleviate concerns that inflation would go out of control. And on May 14, there was surprising news that the Philippines’ weighting in the MSCI Emerging Market index would not be reduced despite the addition of China in the index. Consequently, the PSEi rallied by 5.4 percent from its low of 7,499.26.

While the recent strength of the market could be an indicator that we have already seen the bottom, I don’t expect to see a rapid or “V” shaped recovery. I am inclined to believe we will see a slow or “L” shaped recovery in the stock market for reasons stated below.

Disappointing first quarter earnings season. Similar to the fourth quarter 2017 earnings season, the recently concluded first quarter 2018 earnings season was disappointing, with more than twice as many companies delivering weaker than expected results than those delivering better than expected results.

Only the gaming, property and telco sectors delivered double digit earnings growth. Most consumer and power companies posted slower or negative earnings growth as profits were negatively affected by higher costs due to weak peso and rising commodity prices, or higher inflation. Media companies were indirectly affected too as ad revenues weakened due to several companies’ decision to reduce ad spending as a means to cut costs. Banks suffered from trading losses brought about by higher rates.

Inflation will most likely remain a problem for most of 2018. Despite higher interest rates, inflation is expected to remain a problem. This is not because of the impact of the tax reform program, but due to the continuous increase in the price of oil and other commodities. For example, the price of oil has increased by 18.7 percent from $60.37/barrel at the start of the year to about $71.63/barrel currently. It doesn’t help that the peso remains weak. Higher inflation will continue to hurt the profitability of companies, limiting the ability of their share prices to rally in the short term.

In my opinion, the main reason why the market rallied strongly in the past two weeks was because investor sentiment was just too negative. This was reflected in the depressed valuations of numerous stocks. In fact, at 7,500, most stocks in the PSEi were trading at par or below their 10-year historical average P/Es. As a result, when economic indicators proved that things were not as bad as they seemed, and when the BSP finally raised interest rates to control inflation, the market rallied to more normal levels.

However, as discussed earlier, I don’t think the challenges facing corporate earnings will go away anytime soon. As such, it is premature to expect stocks to rally on a sustainable basis, explaining why I think we will see an “L” shaped and not a “V” shaped recovery.

For the said reason, I think it is better for investors to stay disciplined and stick to the strategy of accumulating stocks only below certain levels using peso cost averaging strategy. Our recommendation is to buy only when the PSEi is trading below 7,900.