Written by Fabiana Fedeli, CIO, Equities, Multi Asset and Sustainability, M&G Investments
As we head into the second half of 2023, markets will likely be preoccupied with the same two key drivers that influenced sentiment in the first half of the year: ongoing central bank decisions and the likelihood, timing and depth of a recession.
Central bank rate divergence
In the US, we’ve had varying opinions from Federal Open Market Committee (FOMC) members on the direction of travel for interest rates from here. Despite diverging views, ultimately, the committee will be data driven. Given the current data, we expect a pause at the June meeting, as the Federal Reserve (Fed) tries to assess how far tightening credit conditions stemming from the US regional banking events are impacting market liquidity. In our view, the Fed is unlikely to cut rates this year, unless we have a deep recession or see inflation drop to 2% – both of which are not in our base case scenario for 2023.
In the UK and Europe, we expect further tightening ahead from the Bank of England (BoE) and the European Central Bank (ECB) given the stickier inflation compared to the US.
Ongoing uncertainty around the shape and timing of a recession
We have seen a number of weak or weakening activity-related data points, recently. However, there has been no clear sign of a major and pervasive deterioration. It feels logical to expect further deterioration in demand as the ‘higher for longer’ rate environment weighs on spending. However, the likelihood, timing and extent of a recession remains uncertain at this point.
Let’s not forget, that recessions can come with a lag. As a barometer, if we look at historic US recessions that appear to have been triggered by a rate hike cycle from 1965 to today, these occurred to varying degrees and appeared with a wide range of lags of between five and 15 months from the last rate hike. Of course, while history may rhyme, it doesn’t necessarily repeat itself. We still believe that market performance, and particularly the relative performance of equities versus fixed income markets, will hinge on the length and depth of a slowdown versus current expectations. In this environment, the market will likely remain data-driven with investors examining each data point closely for clues about the macroeconomic outlook and, by extension, policy decisions.
Near-term outlook for Equities
Commentators are becoming increasingly negative on Equities, basing their arguments on the prospects of a recession ahead. We prefer to take a more balanced view, recognising that while a downward trend of macroeconomic data ahead may be highly likely, the extent of the deterioration versus current expectations will be the real determinant of equity markets performance. On the surface, global equity markets appear fairly priced for the risks ahead assuming a moderate recession, although not for a deeper demand decline. However, below the surface, there are notable differences not only between regional markets but also between stocks in the same market. In particular, the S&P500 Index appears significantly overvalued versus other markets, given fundamentals.
The US market is still trading at close to half the equity yield of other major markets, meaning that it is almost twice as expensive. In past years, a perception of higher quality and relatively higher earnings growth has been supporting such a premium.
Given the recent US regional banking events, and relatively muted earnings growth, the justification for such a valuation premium is looking less plausible in our view, particularly versus Europe. As we wrap up the first quarter earnings season, EAFE (Europe, Australasia and Far East) companies have delivered more robust earnings and sales growth numbers than those in the US, where we’ve seen the S&P Index deliver year-on-year declines in EPS growth.
The breadth in performance has also been different across equity markets. In the US, the recent rally has been concentrated in a handful of stocks, primarily mega-cap technology stocks. In Europe, by contrast, the strongest market rallies (in Germany’s DAX and the CAC in France) have been much broader in nature, extending beyond just the luxury goods names for example.
What has helped Europe, in our view, has been the very pessimistic starting assumptions which have not been realised, particularly on energy supply and prices. Also, we have a number of European companies performing well on the global stage. This has allowed a broad range of corporates to participate in the rally – pharmaceuticals, industrials and consumer-related businesses, as well as those related to the energy transition, which are benefiting from the billions of dollars of green subsidies contained in the US Inflation Reduction Act and expectations of Europe’s attempt to match this.
When talking about broader markets, we stand by our position that this is not a market for ‘broad strokes investing’ (taking directional macroeconomic calls and swinging entire portfolios one way or the other). The market remains one where selection is the main driver of alpha, diversification is key and volatility has to necessarily become our friend. The recent earnings season continues to show that companies are performing very differently, even when in the same sectors, due to tilts in exposure, product mix, pricing strength, balance sheet strength and, ultimately, better management.
Higher-than-average return dispersion both between and within sectors reinforces our belief that selection is the way to deliver alpha in the current environment. In our view, the market offers attractive opportunities for bottom up, fundamental investors who are willing to dig a little deeper.
Attractive value in Japan
Within developed economies, Japan remains one of our favourite markets. We have found a number of companies that are improving operational leverage with a positive impact on earnings growth, alongside increasing shareholder returns via raising dividends and share buybacks, even without the support of the macroeconomic backdrop. However, less well recognised in our view, alongside this culture of self-help and corporate reform, is the prospect of wage growth boosting consumption, providing a further potential tailwind for growth in the years ahead.
After years of short-lived excitement and false starts, and having eventually fallen off the radar for many, there are signs that investors are starting to recognise the potential growth opportunity among Japanese corporates: in May, the broad TOPIX Index reached its highest level since Japan’s stock market bubble burst in 1990. Despite the growing attention from foreign investors, we still believe that the upside prospects for Japanese companies are not fully appreciated and there are compelling opportunities, particularly for active, engaged investors.
One factor to keep in mind for investors wanting to invest in Japan is the impact of currency. The recent announcement of a monetary policy revision from the Bank of Japan (BOJ) could mean a change in monetary policy sometime ahead, but as always when it comes to Japan, in a cautious way. The BOJ is most likely buying time to make sure that the current inflationary pressure is non-transitory and also to combat market speculation of policy change. A change in policy, whether in the form of a further widening of the Yield Curve Control (YCC) band or a rate hike, would support the Japanese yen (JPY). Therefore, when picking stocks in Japan, it is important to consider that for some the currency tailwinds may be a thing of the past. The difficulty will be in determining the timing of a BOJ move as the market has got it wrong many times before. Luckily, there are many stocks where the fundamental tailwinds appear stronger than any potential currency impact.
CHART: Value in Japan
Selective opportunities in China
In emerging markets, we believe that interesting opportunities can be found in China. As always, selection remains important. China’s reopening sparked a great deal of excitement about a rebound of economic activity and markets, arguably, got ahead of themselves. The reality is that after a period of rolling COVID lockdowns, a very weak real estate market and challenged local finances, any recovery was always going to be gradual and uneven – there is scar tissue that will take time to heal.
However, there is room for fiscal and monetary policy to be eased, as has been done with selective support for the real estate and infrastructure sectors – especially in terms of the energy transition. Importantly, there are no inflationary constraints on Chinese policy makers.
Ongoing US-China tensions remain an overhang, and this has manifested itself in a higher risk premium and lower valuations. The tensions are unlikely to go away completely and their impact has to be considered when selecting stocks. The silver lining is that the world’s two largest economies are very closely intertwined through trade – both directly and indirectly through Asian trading partners. Neither side wants, or can afford, major disruption in the current economic climate. Hence, the recent more conciliatory comments from President Biden and low-level meetings taking place again.
Aside from all the macroeconomic noise, we are encouraged by what is happening from a microeconomic or bottom-up perspective: a number of large Chinese companies are doing a good job in terms of margins and profits, despite softer-than-desired headline growth, and we are seeing many companies returning cash to shareholders in the form of buybacks.
Short-term market dislocations and long-term opportunities
In a market where news-driven short-term reactions have become the order of the day, volatility can become our friend, offering attractive opportunities. One of these presented itself among non-US banks, in Europe and even more so in Asia, where many fundamentally sound, and tightly regulated, banks experienced what we believed to be unwarranted share price falls, following the US regional banking turmoil. This sell-off was a good example of the pockets of mispricing that are occurring in an increasingly news-driven market. And there will likely be more ahead as the market reacts to central bank decisions and datapoints that appear to support fears of a deep recession.
While we wait patiently for market dislocations, we continue to like companies exposed to long-term themes that we believe will continue to attract capital even in a global demand slowdown: infrastructure, innovation (such as AI, but also in other intellectual property-heavy areas such as healthcare) and the low carbon ecosystem. As mentioned, the recent earnings season has reminded us that companies in the same sectors can fare very differently due to differences in exposure, product and pricing strength, and – ultimately – management. Therefore, across all of these themes we remain selective.
Our multi-asset portfolios currently hover around a neutral stance between equities and fixed income, and trade tactically around those positions, putting more focus on the underlying composition of the portfolios. We maintain a relative preference for non-US equities, where we find more compelling opportunities from a valuations vis-à-vis earnings profile standpoint.
Our strategies also have a small overweight in duration expressed via the long end of the US curve and some selected emerging market sovereigns and currencies, such as Brazil and Mexico, given the high real yields and the improving inflationary environment.
As we move through 2023, we remain diversified, continue to focus on bottom up, differentiated research to drive alpha, and stand ready to take advantage of tactical opportunities presented by market volatility.
