Rally in equities looks overdone

06 February 2023

Dorothée Deck, Cross Asset Strategist

Key points

  • After a torrid 2022, equities and other risk assets have powered ahead in January – with global stocks registering near 20% gains since their mid-October lows
  • While there’s been welcome economic news of late – such as the sudden reopening of China’s economy and inflation levels receding in both the US and Europe – the recent rally looks overdone
  • With asset prices looking stretched relative to macro-fundamentals, prudence seems warranted and more defensive positioning may be needed to reduce downside risk in portfolios 
  • Equity investors should consider rebalancing their positions towards the more defensive parts of the market, in a very selective way, while multi-asset investors might consider increasing allocations to bonds versus stocks. Option strategies may offer another way to improve the risk-return profile of those investments 

Investors have been in buoyant mood early in 2023, sustaining a rally in equities and other risk assets towards the end of 2022. While there are more positive signs on the economic front to justify their optimism, the rally appears to be overdone. What can investors do to hedge their portfolios against downside risk in financial markets?

Risk assets start the year on the front foot

Equities, commodities and other risk assets, have started the year on a strong footing, extending their gains made since mid-October last year. 

Global equities had already gained 19% from their October lows, outperforming bonds by 13%, by 27 January. Non-US stocks have trounced their American peers by 7% during this period, while industrial metals have soared by 20% following the removal of China’s COVID-19 restrictions. Meanwhile, the US dollar has depreciated by 10% against the currencies of its major trading partners. 

The rally in risk assets since October has been fuelled by expectations that the US Federal Reserve (Fed) and other leading central banks would soon halt their interest-rate hiking cycles, following a general easing of inflationary pressures, thereby increasing the chances of a soft landing for the economy.

However, equity markets seem to have overshot macro fundamentals 

Following the latest economic data releases, inflation has slowed faster than expected, while economic growth has surprised positively, which is generally a favourable environment for equity valuations (see chart). 


That said, investors have taken note and are now pricing in an improvement in the growth/inflation dynamics. However, the rally appears to have run ahead of macro fundamentals, which leaves room for disappointment in the near term.

The chart shows that the rise in global equity valuations observed in the past six months appears to have overshot the improvement in activity surprise relative to the inflation surprise. This is happening in the context of a highly uncertain environment:

- The lagged impact of previous rate hikes on the economy remains unclear.

- Central bank officials have maintained a hawkish stance in relation to interest-rate policy, despite a slowing economy. Policymakers have recently reinforced their message that rates are likely to stay elevated for some time, and probably for longer than the market currently expects. 

- The reopening of the Chinese economy is likely to be a long and chaotic process. The country will probably see a surge in COVID-19 infection rates in the coming weeks, following the Chinese Lunar New Year holiday (7 January to 25 February) - a time when many people travel across the country to visit their relatives. While Beijing seems unwilling to lockdown again, the spread of infections could lead to an increase in self-imposed restrictions that could slow the economic recovery. 

- In addition, the expected boost to global growth from an acceleration in Chinese economic expansion is likely to be lower than in previous years, as it will be led by the services sector as opposed to manufacturing.  

- The fourth-quarter earnings season has produced mixed results so far, and could add to volatility in financial markets. With investors’ focus shifting from inflation to recession risk, corporate earnings releases and managements’ perceptions of the outlook will be heavily scrutinised.

- And finally, with the war in Ukraine still raging, the geopolitical uncertainty is unlikely to subside soon.

With that in mind, we would not chase this rally until we see clear evidence that the economic data is improving and that the peak in interest rates is near.

What could equity investors do to limit downside risk? 

Investors willing to reduce downside risk in equity portfolios should consider rebalancing their positions towards the more defensive parts of the market, but in a very selective way, and preferably via individual stocks rather than sector indices. 

At the stock level, we would focus on companies with a history of stable earnings and solid balance sheets, which have been resilient through previous economic cycles, and trade at a historical discount.

However, we would shy away from global sector indices in the defensive sphere, which seem very expensive at present. Following a substantial re-rating in recent months, such sectors now trade at an extreme valuation premium compared to valuations for cyclicals, based on forward price/earnings multiples. This premium is equivalent to 2.4 standard deviations above its 20-year average. 

Alternatively, investors can also increase defensiveness in multi-asset portfolios via investing in the fixed income market. Following the substantial increase in rates in the past few months, bonds, and credit in particular, now offer an attractive alternative to equities. 

For most of the past ten years, the historically low yields on bonds pushed investors up the risk curve into equities. However, the gap between global equities’ dividend yield and US 10-year bond yields is now the most negative it’s been in the past 12 years, despite higher risks. And similarly, the gap between dividend yields and investment grade corporate bond yields is the most negative since 2008 (see chart).


Finally, option strategies can be a useful tool when it comes to protecting downside risk. We highlight below areas of the market which have performed strongly in recent weeks, and which investors may consider hedging.

Which areas could investors consider hedging? 

1) European stocks

European stocks have had a particularly strong run in recent months (see chart). From their October lows to 27th January, and based on MSCI indices, European stocks have returned 19% in local currency terms and +32% in USD, versus 14% for US equities.


A combination of factors has led to this outperformance:

-  More optimism on the energy front (lower energy prices, combined with a warmer than anticipated winter);

-  The re-opening of the Chinese economy, to which European companies are significantly exposed;

-  Better-than-expected growth and inflation data, especially compared with other regions;

-  Europe’s Value tilt and relatively cheap valuations in a rising rates environment, when Value has outperformed Growth stocks.

However, risks remain in the near term. With growth expectations being revised up, it will be more difficult for economic data to surprise positively. As noted above, the re-opening of the Chinese economy could be slower than anticipated. And finally, the geopolitical situation remains unpredictable and tensions could escalate.

2) Industrial metals

Industrial metals have strongly benefited from the expected boost from Chinese growth this year and a weaker dollar in recent weeks. As of 27th January, they have returned 26% since the end of September. While we remain structurally positive on industrial metals, the re-opening of the world’s second-largest economy may be bumpy, and hit industrial metal prices. Therefore, investors with short investment horizons may consider hedging some of those gains.

Maintaining a prudent stance

In conclusion, the recent rally in risk assets may have run ahead of macro fundamentals. Much uncertainty remains in the near-term and prudence appears warranted. 

Investors willing to reduce risk in equity portfolios should consider rebalancing their positions towards more defensive parts of the market (preferably via individual stocks). Meanwhile, multi-asset investors might consider increasing their allocations to bonds versus stocks. Finally, option strategies could help to improve the risk-return profile of those investments.


Market Perspectives February 2023

Welcome to our February edition of “Market Perspectives”, the monthly investment strategy update from Barclays Private Bank.

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