Equities outlook: Balancing the tactical with the long-term
- Europe’s short-term macroeconomics are challenging but valuations look to have - hopefully at least - bottomed out
- China’s equity valuations have been hit hard but it could potentially rally if its COVID-19 policy is eased further
- The US looks strong geographically and from an investment perspective, global secular trends in place remain
Risk assets have endured a difficult 2022, and none more so than equities, with global shares down some 17% year to date.1
This year has seen some significant headwinds; the aftermath of the pandemic has seen inflation skyrocket and monetary policy tighten, all in the wake of the Ukraine crisis which has sent energy prices – and energy stocks – soaring.
Within the equity market, energy share prices have shot up by some 64% so far this year, while information technology and communications services have respectively dived by 32% and 44%.2 This divergence is symptomatic of the current geopolitical and economic backdrop; energy prices are high due to demand, while the call for tech has eased on the back of slowing GDP growth.
The outperformance of traditional energy stocks this year is not something we see continuing indefinitely, while the secular growth story for technology and clean energy, for example, remains strong. Historically, earnings per share data for IT has grown steadily, while energy has been far more volatile, mirroring the ups and downs of the oil price.3
Uneven playing fields
Corporate earnings have been remarkably resilient this year. However, given the macro indicators have deteriorated we expect there to be some downside pressure on corporate profits. The question is what trajectory it will take; will it be a short, albeit sharp hit, or more drawn out but not as severe? The evidence, in our view, suggests the latter outcome.
Right now, the world’s equity markets are not all in the same place.
In China, Asia, Europe and the UK, it looks like the bad news is largely priced in, and they are trading at a price-to-earning (PE) ratio discount of between 6% to 30% to their historical long-term averages. The US however is trading still slightly above its long-term PE average.4
If there is any positive news on the Ukraine crisis, it will likely be a massive short-term beneficiary for European equity markets. This could generate some tactical outperformance. But if we think about secular growth drivers, they are still all intact and in our view the US, as opposed to Europe, is the place to be over the longer term.
As is the case with any market derating, opportunities will arise though a plethora of challenges remain. However, we believe despite the deluge of bad news, there are reasons to be optimistic as we head into 2023, but for investors it will be about balancing short-term tactical moves with longer-term plays.
The tactical plays
Europe has been hit hard by the energy crisis; year-to-date, shares are down 18%, inflation hit a fresh high of 10.7% in October and the economic outlook is going to remain bumpy over the coming quarters.5 In a bid to tackle rising prices, the European Central Bank (ECB) hiked interest rates by 75 basis points for the second month row in October, bringing the benchmark deposit rate to 1.5% – its highest since 2009. However, the move reflects the ECB’s continued focus on cooling inflation.
Eurozone GDP growth slowed to 0.2% in the third quarter (Q3), from 0.8% in the previous three months; overall, good news is in short supply and currently, we anticipate a -0.5% contraction overall in 2023.6 But importantly markets have priced in the negative news flow. Equally, the four biggest Eurozone economies as well as the UK have all introduced measures to tackle the inflationary backdrop and we expect more to be announced over the coming months.7 By making efforts to mutualise the energy crisis, governments have dramatically reduced its potential economic impact.
Overall, sentiment is poor, investors have sold out, valuations have now derated to if not quite rock bottom very nearly so, and the macroeconomic backdrop is very shaky – but such an environment is often when long-term investors look to buy. And certainly, if there is any de-escalation of the Ukraine crisis, European markets could enjoy a significant rally, at least in the short term, with cyclical sectors including banks and industrials, as well as the more energy-intensive industries, such as chemicals and auto manufacturers, most likely the primary beneficiaries.
Elsewhere China has the potential to rally. Valuations there have derated to historic lows and it is facing several significant challenges including the impact of its ‘Zero-Covid’ policy, its beleaguered property sector, and the issues around the government’s dampening down of the private sector.
But it is likely the Chinese economy will start to reopen in the first half of 2023 as it slowly relaxes COVID-19 restrictions, which in turn should help consumer and business demand pick up. We also believe the government will make some concessions, given it has been quite hard on the private sector. If these come to pass, the Chinese market should enjoy a reasonable bounce; we’ve recently seen its market rally on the back of hopes that the Zero-Covid restrictions would be eased, and some have suggested it could rally by as much as 20% if China fully re-opened, but it is a tactical play.8
The long-term play
Compared to Europe and China, the US looks in relatively better shape. US Q3 economic growth came in at an annualised 2.6%, ahead of expectations and a sharp swing back from the 0.6% drop in GDP during Q2.9
In addition, the peak of the interest rate cycle looks like it is - hopefully - in sight; inflation is already starting to come down. Politically after the US midterm elections we expect something of a standstill for the coming two years where in our view, nothing particularly bad, or indeed particularly good, is likely to happen.
From a big picture perspective, the US is very economically diverse; it has a greater degree of energy security; it has better demographics; employment is solid; and it has a highly entrepreneurial mindset. All the world’s secular growth drivers - clean technology, automation, digitisation and biotechnology - are very much in play there.
It is also benefitting from two pieces of recent legislation which should provide considerable tailwinds, namely the CHIPS and Science Act and the Inflation Reduction Act.
The CHIPS Act, signed into law by President Joe Biden in August 2022, is providing an investment of $280bn to ramp up and ‘reshore’ US technology such as semiconductor production. According to the White House it will “strengthen American manufacturing, supply chains, and national security, and invest in research and development, science and technology” to ensure the US remains “the leader in the industries of tomorrow, including nanotechnology, clean energy, quantum computing, and artificial intelligence”- all of which bodes well for the structural trends already in place.10
In addition, the introduction of the Inflation Reduction Act (IRA), which also went live in August this year, has heralded something of a sea change in the US; the World Bank expects it will dramatically change the economics of industrial decarbonisation.11
Essentially the IRA has been enacted to help spur on the private sector to decarbonise hard-to-abate sectors. The IRA has earmarked some $500bn in new spending and tax breaks designed to bolster clean energy investment, cut healthcare costs, and raise tax revenues.
It has accelerated areas that people never thought the US would take a lead in. After being viewed as a laggard it now could be a significant decarbonisation leader, driven by government policy and the economic opportunities.
Biden has set a target to employ tens of thousands of workers to deliver 30 gigawatts of offshore wind by 2030 – comfortably enough to supply 10 million homes with clean energy while still creating new jobs.12
But while the future looks bright for the world’s largest economy, the market hasn’t covered itself in glory this year with the S&P 500 down 16% year-to-date.13 However, there has been a healthy valuation reset in some of these structural growth areas and vitally, the fundamental long-term underlying trends remain the same - the shift to the cloud continues, the software revolution continues, automation will continue to evolve and grow. Valuations for what we see as the highest-quality companies, while not cheap, are at least at more attractive levels. In addition, an end to monetary tightening and some easing of inflation would boost sentiment amongst global equity investors.
Right now, Europe is in the eye of the storm of the energy crisis; short-term macroeconomics are challenging but valuations look to have - hopefully at least - bottomed out.
If there is any resolution to the situation in Ukraine, there would be massive beneficiaries both in the consumer and industrial economy. Equally, if there is any meaningful further alleviation of COVID-19 policy in China and increased activity there, that would help Europe from an export perspective – so we believe there are several factors which could help drive a potential recovery.
Looking further ahead, what looks strong geographically is the US and within that from an investment perspective, the global secular trends in place remain – digitalisation, automation and clean technology and in the one area where it was seen as a laggard – decarbonisation – is now emerging as a global leader.
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