Global equities have experienced some serious turbulence this year – from war, inflation shocks, interest rate hikes and more. But is there light at the end of the tunnel for 2023?
Key takeaways
· As the dust begins to settle on an unprecedented period of volatility for equity markets, we can see opportunities for economic growth in 2023, especially in Asian markets.
· Although equities have fallen in value over the year so far in the UK, company earnings have increased, while in Europe cyclicals are among the cheapest in the region.
· As economies start slow down and potentially face recession, ETF investors could begin 2023 favouring equities with high quality and low volatility characteristics.
Macroeconomic backdrop
Since the Global Financial Crisis, we’ve seen extreme levels of quantitative easing by central banks, along with a disinflationary and low economic growth backdrop.
But 2022 has been a year of unprecedented volatility for equities. The picture varies slightly from region to region, but there have been headwinds from several directions.
Some key challenges
Inflation
- A key issue facing global economies is inflation. Some of the factors driving this are temporary in nature, such as frictional costs in supply chains as the world emerges from the pandemic. But there are also other secular pressures like deglobalisation, changing demographic patterns, and energy transition – to name but a few. Rapidly rising energy costs are having second and third order effects on agricultural and industrial cost bases. This is also adding to the pressures.
Rising interest rates
- In a bid to control persistently high and rising inflation, central banks in nearly every major economy have enacted a raft of interest rate increases. The idea is to slow growth by decreasing spending. But the world has become increasingly financially integrated over the last 50 years, so the effects of individual actions can flow across borders. Cooling inflation in one economy can exaggerate problems in another due to changing import/export costs. This lack of policy coordination is unlikely to leave any single economy unscathed.
Geopolitical unrest
- Russia’s invasion of Ukraine in early 2022 sent shockwaves through global economies. Not only did it put additional pressure on supply chains, sending costs soaring but also raised questions of energy supply and security – especially in Europe.
In our equities outlook for 2023, we visit some of the major global regions, where our teams share their views on what they believe is to come for their market.
| UK Equities by Martin Walker, Head of UK Equities |
UK equities offer significant value, with good earnings momentum, in a currency that is now particularly undervalued
Challenges
A strong US dollar
- The challenge for international investors in UK and European equities this year has been the strength of the US dollar. Over the year, it has benefitted from a global flight to safety at a time of war in Europe. It has also benefitted from concerns around the UK and European economies as a result of significant tensions in energy markets.
Political turmoil
· Since the summer, political chaos has been added to the mix with the resignations of both Boris Johnson and then Liz Truss as Prime Minister. However, the appointment of Rishi Sunak at the end of October has already brought a fragile calm to currency and gilt markets.
· If, as we expect, credibility in Government begins to emerge, equity investors will refocus their attention on what really matters – company fundamentals and cash flows. While we understand that sentiment on UK domestic issues has been a drag on market performance since the summer, investors should appreciate that UK corporate earnings are not a proxy for the UK economy. Only around 25% of the revenues are derived from the UK’s GDP. The rest are international.
What can earnings tell us?
- In an environment of so many moving parts, we believe it is instructive to look at UK equities through the lens of earnings. The below figures show that, while UK equities have fallen in value over the year so far, their earnings have actually increased.
| UK equities (as represented by the FTSE All Share) Earnings are up…Consensus estimates for return-on-equity (ROE) have increased by 19%. Despite this, valuations are down…In price-to-book terms, UK equities derated by 19%. And the UK market is undervalued compared to international peers…The US equity market has derated by a similar amount to the UK (21%), but its ROE has only increased by 3%. |
The key takeaway is that, in the fog of global and UK geopolitics, the quality of returns and the valuation opportunity on offer in the UK has been missed.
The bottom line: What’s in store for 2023?
· UK equities offer significant value, with good earnings momentum, in a currency that is now particularly undervalued. The bottom line is that nominal growth should, in an undervalued market, boost the outlook for UK listed equities. Key beneficiaries will likely include high quality, cash generative businesses, which form a significant part of our portfolios.
· This last point remains key. While we are optimistic about the UK market, our portfolios are what excite us the most. We are invested in high quality, cash-generative businesses with strong liquidity. We believe they will emerge from the current period of disturbance and uncertainty in an even better competitive position than beforehand.
| European Equities by John Surplice, Head of European Equities |
Cyclical stocks among the cheapest in Europe
· Since the Global Financial Crisis, quantitative easing by central banks disinflation and low economic growth have supported growth assets. But as we move to a more inflationary world, where there’s greater balance between fiscal and monetary policy, we struggle to see how these types of assets can continue to outperform.
· Furthermore, the recent war in Ukraine has highlighted Europe’s need for energy independence. We think policymakers will provide incentives to reduce consumption, upgrade incumbent infrastructure and step-up the build out of alternative energy supply.
· All these actions, combined with more nominal growth, are good for domestic European capex plays. These cyclical areas are also currently amongst the cheapest in the region.
· However, our funds are not purely cyclical bets. We also have defensive stocks: companies within pharmaceuticals, telecommunications, insurance, and food retail – which are more resilient to economic downturns, yet equally are not at risk from the inflationary pressures to valuations.
· As the market transitions to the new regime – that of more fiscal control, more inflation, and more volatility – investors should expect to see a great share of performance coming from a fund’s alpha. Bottom-up analysis will be crucial. We feel our strategies are well placed to capitalise in this environment.
| Asia / EM Equities by William Lam, Co-Head of the Asian & Emerging Markets Equities |
Emerging markets and Asian valuations are attractive
Asian equity markets have not been immune to global macro headwinds, including rising interest rates, a strengthening US dollar and lingering recession risks. Geopolitics remain in focus as the Russia-Ukraine conflict and US-China tensions add to uncertainty.
However, domestic macroeconomic conditions in Asia should continue to remain largely stable in 2023, with inflation at more comfortable levels than in the US and Europe. Many countries in the region are at an earlier stage in their economic cycle, with rising incomes and consumer penetration a tailwind to structural demand.
The lack of visibility on how and when China may navigate away from its Zero-Covid Policy remains a key issue, with additional concern over property market weakness. Markets are currently pricing in a very pessimistic outlook, but any roadmap for change would be very positive for Chinese equities. In our view, we have no reason to believe that policymakers will not come forward with a credible economic plan.
Equity market valuations for Asia, as measured by traditional metrics such as price to book ratios, are currently well below long-term averages, at levels which have historically been a good entry point to buy the market. Periods of excessive pessimism provide us with attractive buying opportunities, making Asia an attractive destination for active stock pickers.
Emerging markets (EM) are already a year into their correction from post-pandemic highs, and although further downgrades to consensus earnings growth estimates for 2023 may unfold. We believe valuations are increasingly attractive in both absolute and relative terms.
Indeed, we would highlight that historically, high commodity prices have provided a tailwind for earnings in EM. Combined, we feel this makes EM an attractive place to be investing over the medium-term, with the continued divergence in performance and valuations between different countries and sectors providing opportunities for active investors.
| Equity ETFs by Christopher Mellor, Head of EMEA ETF Equity & Commodity Product Management |
Demand for ESG and thematic ETFs in 2023
Given the uncertainty and market headwinds leading into 2023, we’re likely to see many investors rotate into more growth-oriented exposures sometime in the year.
The trigger could be the Federal Reserve’s eventual pivot from its tightening[1] policy with, of course, the million-dollar question being when that point will be. Inflation is likely to be key, so monthly data will be watched closely.
While most economies face recession or at least a slowdown in activity, investors could begin the year favouring equities with high quality and low volatility characteristics.
ETF investors might consider gaining this exposure through either factor-based “smart beta” strategies or passive funds that follow indices such as high dividend low volatility variations or defensive sectors like consumer staples. Investors may choose to use more of their risk budget in areas of the market that have been heavily sold off and, therefore, may offer better value.
Any improvement in market sentiment could see investors increase risk by rotating into higher beta exposures. In the US, for example, this may include a shift from more defensive positions to ETFs tracking the Nasdaq 100 or even venturing into small and mid-caps, which often benefit from a better domestic economic environment.
Emerging markets and China could also be more attractive.
Investors with specific ethical considerations have been less sensitive to economic shifts in 2022, so continued demand for environmental, social and governance (ESG) ETFs is anticipated throughout 2023. In addition to core equity exposures, we believe an upturn in the economy could drive demand for thematic ETFs, including those involved in the transition to clean energy and more sustainable food and water sources.
