Brace for near-term squalls, position for long-term opportunities

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

Key points

• Equity markets have been more resilient than many anticipated, given the uncertain macroeconomic backdrop. Following a 21% rally from October’s lows, equity markets now appear to be discounting a soft landing of the economy. This is in stark contrast to the recession priced in by the bond market and anticipated by several economists
• The near-term outlook for equities looks challenging, as markets appear to have run ahead of fundamentals, driven by a narrow group of stocks and defensive positioning. However, long-term prospects remain encouraging, with stocks still expected to outperform bonds meaningfully over a 10-year investment horizon
• In this context, downside protection seems warranted. A more defensive but balanced positioning also makes sense. With most indices now looking stretched, the bulk of the opportunities rest at the stock level
• At this stage of the cycle, quality businesses trading at a reasonable price, cyclical stocks trading at a deep discount to history, and already discounting a severe recession, and long-term structural plays that are less correlated with short-term market moves appeal

Equity markets have been very resilient in recent months, and certainty more resilient than many market participants had anticipated given the uncertain macro backdrop. There is now a significant disconnect between what equity and bond markets are pricing in (a soft landing versus a recession, respectively). 

With global growth slowing and central banks guarding against cutting rates too soon, the disconnect between the equity and bond markets seems more likely to resolve itself at the expense of the former. Crucially for investors, while the near-term outlook looks challenging, long-term prospects remain encouraging. 

The article looks at how investors might position portfolios to protect against downside risk in the near-term, while capitalising on attractive long-term opportunities.

Equity markets rebound strongly 

Global equities had rallied 21% from their October lows by 2 June and are back to their February highs. Interestingly, most of this performance was achieved before the start of the quarterly earnings season mid-April.

While corporate profits were generally better than feared in the US and Europe, they came on the back of lowered expectations, and corporate guidance was not strong enough to provide an additional impetus to markets.

… primarily driven by positive economic surprises and hopes of a peak in interest rates

The increase in equity valuations in the past few months has been consistent with an improvement in the growth/inflation mix, relative to economists’ expectations (see chart).

The global equity rally has been consistent with a better-than-expected growth/inflation mix

Six-month change in global equities’ trailing price-to-earnings ratio, against global economic surprise minus inflation surprise indicators

However, macro uncertainty, narrow leadership and market dynamics raise questions about the sustainability of this rally

The positive macroeconomic surprises mentioned earlier, which have supported the market in recent months, are unlikely to remain a tailwind over the long term. Economic surprises are mean-reverting by nature: economists (and investors alike) tend to raise their expectations in the face of positive data surprises, making it more difficult for subsequent data releases to beat their forecasts. Activity surprise has already rolled over in most regions since the end of March, and even turned negative in the eurozone. 

In addition, rates are likely to remain elevated for an extended period of time, unless we see a significant rise in unemployment or a meaningful increase in financial stability risk.

Finally, the narrow leadership and internal dynamics of this rally potentially hinder its endurance.  Since the October lows, cyclical sectors have performed in line with the more defensive ones globally. Meanwhile, financials have underperformed the rest of the market by 7%, small caps have underperformed large caps by 5% and, within metals, copper has lagged gold by 10%.

Such a pattern is unusual in a historical context, as strong and sustainable equity rallies tend to be led by the more cyclical parts of the market and coincide with the outperformance of risky assets against safe-haven ones.

A recession sometime in the next 12 months is widely anticipated …

The global economy is expected to slow in the second half of the year, potentially entering a recession, as the aggressive tightening in monetary policy and credit conditions seen in the past year filters through the economy. It is worth noting that in the past 30 years, hiking cycles that were accompanied by tighter lending standards have always led to US recessions (albeit history is never a guarantee of the future).

Arguably, a global recession sometime in the next 12 months is a widely-held call. A consensus of economists now expects global gross domestic product growth to drop below 3% in both 2023 and 2024, according to Bloomberg.

… but its timing and severity are more difficult to call

What is more difficult to predict though, is the timing and severity of the next recession, which will be key determinants of financial asset performance. Monetary policy impacts the economy with long and variable lags, which will be exacerbated in this cycle by the recent strains in the banking sector.

Our central case remains that if a global recession materialises, it is more likely to be mild and short-lived, due to the absence of major imbalances in the economy or financial markets at present. Our view assumes that the banking crisis should remain contained.

The equity market appears to be pricing a soft landing of the economy…

Based on historical relationships, global equities appear to be discounting an improvement in the macro environment, with a rebound in economic activity and corporate earnings growth. 

Historically, there has been a strong correlation between equity prices and economic activity (see chart). At current levels, global equity prices are discounting an improvement in the Institute of Supply Management (ISM) manufacturing index from 47 for the month of May to approximately 52 as of 2 June. A rebound above the 50 level would suggest that the manufacturing sector moves back into expansion territory.

Global equities appear to be discounting a soft economic landing

12-month change in global equity prices, against the ISM Manufacturing Index

Bonds look more attractive than equities in the near term

Following the surge in bond yields in the past year, and as highlighted in previous articles, fixed income markets look more attractive than equities in the near term (see chart). They provide a higher yield for a lower risk.

Looking at relative valuations between equities and government bonds, the global equity risk premium has fallen to 3.3%, compared with 6.2% in March 2020 and 20-year average of 4.2%.

The gap between global equities’ dividend yield and bond yields is the most negative since the global financial crisis

The global equities dividend yield compared with the Bloomberg global aggregate Treasury bond yield and investment grade corporate bond yield

However, the long-term outlook for equities remains constructive

While the risk-reward for equity markets looks mixed in the near term, the longer- term picture is more positive, with stocks likely to outperform bonds meaningfully over a 10-year investment horizon.

Historically, cyclically-adjusted price-to-earnings (CAPE) ratios have been reliable indicators of long-term expected returns. At current levels, CAPE ratios suggest that global equities could generate annualised returns of 8% in the next 10 years, including dividends. While slightly below the 9% total returns posted in the past two decades, those returns are well above global bond yields of 3% at present over a similar period (see chart).

Cyclically-adjusted price-to-earnings ratios suggest that global equities could generate annualised returns of 8% in the next 10 years, including dividends

Comparing global equities’ cyclically--adjusted price-to-earnings ratios and annualised returns in the subsequent 10 years, including dividends

How should investors be positioned in this environment?

At the asset-class level

With that in mind, and given the difficulty in timing a recession, long-term investors should stay invested, but with downside protection in place (see The brightest binary star in the investment universe, and Waiting for a tipping point). 

Options and capital protected strategies can be used to mitigate downside risk in portfolios and enhance risk-adjusted returns. Interestingly, and despite the current market uncertainty, implied equity volatility remains suppressed, which means that option strategies can still be implemented at a relatively cheap cost. Of note, put/call ratios in Europe and the US have been rising since the start of the year, suggesting renewed interest in downside hedges.

At the sector level

Investment opportunities at the sector level seem limited, in our view. All sectors appear to have overshot their historical relationship with economic activity and credit conditions. 

While cyclical sectors trade at an 8% discount to historical levels globally, their earnings are closely tied to the business cycle and would suffer the most in a recession. On the other hand, defensive sectors’ earnings tend to be more stable throughout the cycle, but they have significantly re-rated in recent months and now trade at a 25% premium versus history. In relative terms, the valuation premium of defensives versus cyclicals is now extreme, at over three standard deviations above its 20-year average, based on trailing price-to-earnings multiples (PEs).

Two sectors stand out as looking particularly cheap at present: energy and banks. They are currently trading at 1.5x and 2.4x standard deviations below their 10-year average, respectively, based on forward PEs globally. They also offer superior dividend yield prospects over the next 12 months, of 4.4% for energy and 5.3% for banks, versus only 2.3% for the broader market. 

With regards to the banking sector, the valuation discount seems justified given the high level of uncertainty that is likely to prevail in the foreseeable future. The collapse of three US regional banks in March will lead to increased regulatory and liquidity pressures, and their impact on the sector’s long-term profitability is difficult to assess at this point. Volatility is likely to remain elevated in the sector, and in the absence of a catalyst, the sector is unlikely to re-rate.

However, in the case of the energy sector, depressed valuations represent an attractive opportunity for long-term investors. Energy stocks have underperformed in recent months, due to recession fears and the decline in the oil price.

That said, stock prices have lagged their relationship with earnings, and the oil price should be supported by tight supply dynamics. The sector also represents an attractive a hedge against inflation and geopolitical risk. Therefore, despite its sensitivity to a slowing economy, adding exposure to the energy sector on weakness may have merits. With the sector likely to remain volatile in the near term, shorter-term investors should favour capital protected structures.

At the regional level

We see a similar picture at the regional level, with most markets offering a mixed risk-return profile in the near term.

However, if we take a step back and focus on long-term return prospects, attractive opportunities can be found selectively at the regional level.

Global equities trade at 15.6x forward earnings, in line with their 10-year average, but with significant divergences by region.

The US market trades at a slight premium to its historical average. Large-cap growth and technology stocks, which have driven the rally, look vulnerable if rates remain higher for longer than expected. 

However, some markets such as eurozone and UK equities look particularly cheap relative to history. Despite near term challenges, they represent attractive value for long-term investors, who can tolerate the volatility. 

The market perception is that European equities are likely to underperform their US peers in a recession, as their sector composition is more cyclical. However, there is no evidence to support this contention. The last 50 years shows that the performance of US and European equities during recessions, from their peak to trough, has been around the same.

At the stock level

While most indices are now looking extended versus macro fundamentals, we believe that attractive investment opportunities can still be found in the near term at the stock level. 

As discussed in Tighter credit conditions call for increased selectivity, the dispersion of returns within the equity market is unusually low considering that a recession is looming. Stocks have been highly correlated with each other in the past year, driven by common macro factors more than idiosyncratic risk. However, the dispersion of returns should expand in the coming months, as investors become more discriminating and reallocate capital into higher-quality businesses. This should open up more stock picking opportunities.

At this stage of the cycle, a more defensive, but balanced, positioning makes sense. Investors should focus on reasonably priced companies with established businesses, superior pricing power, stable margins and strong balance sheets. Opportunities can also be found among the more cyclical businesses and those exposed to the credit cycle, as long as they are trading on depressed valuations and discount a deeper recession than expected. 

Finally, long-term structural plays are worth considering, as they tend to be less correlated with short-term market moves. Certain investment themes look particularly attractive at present, such as generative artificial intelligence and security (energy, food and cyber security, as well as defence).

In conclusion

Equity markets appear to have run ahead of the macroeconomic fundamentals, driven by a narrow group of stocks and defensive positioning. This implies downside risk to equity prices in the near term, if the economy contracts and corporate earnings decline, as our base case assumes. 

In that context, a more defensive but balanced positioning makes sense. With most indices now looking stretched, the bulk of the opportunities lies at the stock level. The good news is that the dispersion of returns looks set to rise in the coming months, as the economy slows down and the weaker players are exposed, opening up more stock picking opportunities for investors.