Market dislocations create opportunities for equity investors

• Equity investors have faced a challenging start of the year, as market attention has shifted from inflation to growth dynamics, amid increasingly hawkish central banks
• While markets are likely to remain highly volatile in the near term, we believe the recent sell-off has created opportunities for long-term investors
• The prevailing uncertainty warrants increased diversification and selectivity in portfolios
• We highlight in this article some areas of the market which appear dislocated

It’s been a challenging start of the year, as market attention shifted from inflation to growth dynamics, amid increasingly hawkish central banks. While markets are likely to remain highly volatile in the near term, we believe the recent sell-off has created opportunities for long-term investors. The prevailing uncertainty warrants increased diversification and selectivity in portfolios.

Given the high level of uncertainty in the outlook for economic growth and inflation, equity markets will likely remain volatile in the short term. However, on a 12-month view, we expect equities to rebound and outperform bonds. Following the recent market sell-off, equity valuations have normalised. If, as we expect, inflation moderates in the second half of the year and growth expectations stabilise, this creates opportunities for longer-term investors, who can weather market turbulence in the coming months.

What’s changed?

Since we published November’s Outlook 2022, the environment for risk assets has deteriorated. Central banks have become increasingly hawkish, as inflation has been higher, and more persistent, than expected. The demand-driven, post-pandemic rise in prices has been further exacerbated by the war in Ukraine and China’s COVID-related lockdowns. As a result, growth expectations have been cut and inflation forecasts lifted.

Today, the main concern for investors is whether the US Federal Reserve and other central banks will be able to engineer a soft landing and bring inflation down to their target level, without triggering a major growth shock or even a recession.

An uncertain macro outlook

The outlook for growth and inflation remains highly uncertain at present, given the binary nature of the forces at play.

The geopolitical situation in Russia and Ukraine could improve in the coming weeks, but the economic impact of the sanctions on the former will very much depend on their details and will likely have a longer-lasting impact.

Similarly, it is hard to predict how the COVID-19 situation will evolve in China. Beijing remains committed to its zero-COVID policy, and until the economy fully reopens, the lockdowns will continue to weigh on activity and global supply chains. The Chinese government signalled that it will step up support for the economy. However, the size of the stimulus will be key and its effectiveness will depend on the level of restrictions.

Market reaction

Unsurprisingly, given the worsening of the macro outlook, the equity market reaction has been brutal. Global stocks have declined by 17% so far this year, underperforming bonds by 4%.

The dispersion of returns has also been striking, with high valuation and long-duration assets being hit the most, due to their sensitivity to rising yields. In the MSCI World index, consumer discretionary, technology, and communication services have lost 23% to 30% of their value. By contrast, energy has gained 42%. At the style level, value has outperformed growth by 26%.

It is important to note that the market pullback has been driven by multiple contraction, as earnings have remained resilient, so far.

Where do we go from here?

In the near term, and until we get more clarity on growth and inflation prospects, equity markets are likely to remain highly volatile. However, over the longer term, downside risks appear limited.

Valuations: Global equity valuations have declined significantly in recent months, and are now back in line with their long-run averages, in absolute terms and relative to bonds.

• Equities are now trading on a forward price-to-earnings multiple of 14.7 globally, down from 18.4 at the start of the year, and in line with their 20-year average (see chart)
• Similarly, the global equity risk premium (ERP) is essentially in line with its 20-year average, at 3.9%. We believe this premium is adequate to compensate investors for owning stocks relative to bonds, especially in a high inflationary environment. We note that the ERP is significantly more attractive in Europe than in the US, at 6.9% vs 3.0% respectively at present.

For stocks to re-rate over the coming months, we would need to see an improvement in the mix of growth and inflation. Until then, the upside potential for equity markets relies on the resilience of corporate earnings. 

Earnings: We believe that consensus earnings forecasts are too optimistic and will need to come down, to reflect the increased headwinds, not least elevated inflation, that companies are facing. However, we expect earnings growth to remain positive this year.

• Bottom-up analysts currently expect earnings to grow by 11% this year globally and by 8% next year
• However, during the first-quarter earnings season, companies have been more cautious on their outlook for growth and inflation, and their objective has clearly shifted to margin preservation rather than expansion
• In the past 12 months, margins have been the main contributor to earnings growth. But they are now close to all-time highs (earnings before interest and tax margins are now at 12.8% for non-financial companies globally), which means that it will become increasingly difficult for companies to protect margins if inflationary pressures persist
• While first-quarter earnings have generally been resilient in the US and Europe, growth has largely been driven by the commodity sectors. Excluding energy and materials, earnings expansion would have been up only 2.0% in the US (versus 9.4% in aggregate for the S&P 500) and down 8.9% in Europe (against 10.8% in aggregate for the STOXX Europe 600).

What’s priced in: Encouragingly though, after the recent pullback, a lot of bad news already seems to be priced in. At current levels, and on our numbers, global equities are discounting around a 4% decline in earnings this year, well below the 11% increase expected by analysts.

• Such a decline in earnings would be consistent with a sharp slowdown, and an Institute for Supply Management index reading just below 50 by year-end (where a reading below 50 suggests an economic contraction), but not a recession (see chart)
• In the past 50 years, global earnings have declined by 24% on average, year-on-year, around recessions (ranging from -10% in 1982 to -40% in 2009)
• Should a prolonged recession materialise, which is not our base case, there would be more downside risk to equity prices
• For context, over the same period, previous recessions have led to average peak-to-trough drawdowns of 36% (ranging from -15% in 1980 to -60% in 2009), which lasted 12 months on average. This compares with a 17% drawdown for global equities from their early January peak, at the time of writing.

To summarise, we expect earnings growth to be revised down in the coming months, but to remain positive. Based on fundamentals alone and assuming low-to-mid-single digit growth in earnings, combined with flat to modestly higher price-to earnings (PE) multiples, global equities could generate mid-to-high-single digit total returns in the next 12 months. In the near term though, the growth / inflation mix remains highly uncertain and equity market volatility is likely to persist.

Investment implications

Given our macro outlook, we prefer to stay invested, but position portfolios for an extended period of high volatility and keep some hedges in place. The current uncertainty warrants increased diversification across sectors, regions, and styles.

As such, we favour a mix of defensive and cyclical assets, in a barbell strategy, to reduce downside risk in case of another sell-off, while also taking advantage of undervalued opportunities in dislocated parts of the market.

Within defensives, we prefer sectors with predictable earnings, stable margins, and strong pricing power. Our preferred sector in the defensive space remains healthcare.

The healthcare sector has rerated significantly already, from an 8% discount to the market at the start of the year, to an 8% premium today (based on forward price-to-earnings multiples and the MSCI World Healthcare and MSCI World indexes), slightly above its 20-year average. However, we see room for a further rerating in a risk-off phase, and believe that the sector would also be supported by its more resilient earnings stream.

Within cyclicals, we favour sectors which have overreacted (or underreacted) to the recent change in the economic environment, and now appear fundamentally undervalued. More specifically, we look for sectors which have overshot their historical relationship with activity on the downside (proxied by the ISM manufacturing), or sectors which have failed to reflect the substantial rise in yields in recent months and now offer some catch-up potential. This approach highlights industrials and banks as particularly attractive at the moment.

Both sectors were highlighted in November’s Outlook 2022, and the investment rationale remains in place.

• Industrials: Global industrials have suffered from their strong correlation with activity, as growth expectations have been cut. The sector has underperformed the broader market by 6% since July last year, discounting a significant slowdown which seems overdone at this stage. If growth expectations stabilise as we expect, this underperformance should reverse. Industrials are also likely to benefit from an increase in capital expenditure programmes in the coming months (including in the fields of energy independence, defence and green initiatives), and they trade at a small discount to the market compared to their long-term average
• Banks: The 8% outperformance of the banking sector this year appears relatively muted, considering the sharp rise in bond yields (see chart). Historically, banks have tended to outperform in periods of rising yields, often associated with improving economic momentum. Stronger loan growth, wider net interest margins, and better asset quality generally lead to stronger profitability.

However, the recent rise in yields was driven by increased inflation expectations and hawkish central banks, as opposed to stronger growth. Once inflation starts to moderate and growth concerns abate, we would expect the sector performance to catch up with yields. Despite a significant rerating since the end of 2020, global banks still trade at a large discount to the market, relative to history (-1.3 standard deviations below their 20-year average). 

With regards to the energy sector, we would not allocate new money to it at current levels, following its phenomenal run (the MSCI World Energy index is up 38% year-to-date). However, for investors who already have some exposure to the sector, it might be worth maintaining the position as a hedge against inflation and geopolitical risk. The sector would obviously be at risk of a de-escalation of tensions between Russia and Ukraine, and any significant decline in the oil price.

At the style level, we continue to favour cyclicals over defensives and see opportunities in small caps for similar reasons. Both discount an overly bearish economic outlook, have disconnected from the recent rise in yields, and are trading at steep valuation discounts.

At the regional level, and based on our sector views, we would look for opportunities in non-US equities, and European stocks in particular. While European equities underperformed the US by 10% in the immediate aftermath of Russia’s invasion of Ukraine, they quickly recovered and are now up by 17% relative to the US since the beginning of March, in local currency terms (+13% in relative terms in USD). Despite the recent re-rating, European equities continue to trade at a substantial discount against their US peers, based on forward PEs (-1.7 standard deviations below their 20-year average).

At the stock level, and given the lack of clear direction in the near term, we would focus on secular growth stories, which are less correlated with market moves. 

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