Time for more defensive equity positioning?

Please note: All data referenced in this article is sourced from Refinitiv Datastream unless otherwise stated, and is accurate at the time of writing.

Key points

• 2024 is likely to be another challenging year for equity investors
• While the long-term picture remains bright, the short-term outlook is clouded by elevated uncertainty and demanding valuations
• With that in mind, and given the difficulty in timing markets, staying invested remains preferable but investors would do well to consider downside protection and a more defensive positioning
• In 2024, opportunities are much more likely to materialise at the sector and stock levels rather than at the index level

Global equities soared by 28% from their October 2022 lows to their July 2023 highs, but subsequently reversed some of those gains. At the time of writing, they are up 6% year-to-date, or 17% from their October 2022 lows. 

Equity markets face a number of challenges 

It is clear that going into 2024, equity markets face a challenging environment, characterised by a deteriorating growth outlook, elevated yields, higher oil prices, and heightened geopolitical uncertainty.

Growth slowing down 

While growth has been more resilient than expected in 2023, it is expected to slow down in the coming months. 

The implications for risk assets in general will depend on the shape and severity of the downturn. Encouragingly, our economists do not anticipate a severe downturn, due to the absence of major imbalances in the system at present.  

Yields expected to stay ‘high for longer’

While inflation has convincingly moved past its peak in most economies, it remains above central banks’ targets. As long as this remains the case, central banks will be reluctant to ease their monetary policy stance, unless we see a significant deterioration in the economy or the financial system.  

In addition, concerns over swelling budget deficits and associated bond issuance could still push long-term yields higher. Therefore, rates are likely to remain elevated for an extended period of time, which will put pressure on equity market valuations.

Higher oil prices and geopolitical risks 

If sustained, the significant rise in the oil price seen in recent months poses an additional threat to global growth, and could derail the disinflationary path. Oil prices initially jumped by close to 35% between the middle of June and late September, following production cuts by Saudi Arabia and Russia, before paring back some of those gains on expectations of a decline in global demand. However, following the rise in geopolitical tensions in the Middle East, the oil price has started to move up again.

History shows that sharp and sustained increases in the oil price have often led to significant equity market sell-offs, especially when driven by supply factors. For more details on the implications for equity markets, please refer to our October article, ‘Should investors worry about surging energy prices?’.  

While it is impossible to predict how the conflicts in the Middle East and Ukraine will evolve, they do raise the level of uncertainty and the equity risk premium (i.e: the excess return equity investors would expect to receive, compared with a risk-free rate).

In the near term, a more selective investment approach appears warranted

Despite the recent pull-back, broad equity markets seem to have run ahead of macro fundamentals, with valuations looking stretched given the weak macro backdrop, and earnings likely to disappoint overly optimistic expectations.

Based on their historical relationship with the ISM Manufacturing index and corporate profits, global equity prices appear to be discounting a significant improvement in economic activity, and double-digit growth in global earnings over the next six months.

This would be consistent with a ‘no landing’ scenario, and implies a sharp reacceleration of the economy from current readings. This scenario is possible but unlikely. Other indicators, which tend to lead earnings growth, suggest that global earnings are more likely to contract in the coming months. US bank lending standards are consistent with a double-digit decline in global earnings over the next six months, while the new orders component of the US ISM Manufacturing index implies a mid-single digit decline in the next nine months.

Equities’ recent performance is consistent with a ‘no landing’ of the economy

Based on their historical relationship with the ISM Manufacturing index and corporate profits, global equity prices appear to be discounting a significant improvement in economic activity, and double- digit growth in global earnings over the next six months.  

Global equities appear to be discounting a reacceleration of economic activity 

12-month change in global equity prices vs. US 10-year Treasuries, against the ISM Manufacturing Index

Valuation disconnect

Similarly, equity valuations appear extended relative to real yields. Equity markets typically de-rate in periods of rising real yields. However, the opposite trend has been observed since October last year, which coincides with the equity market trough. Over this period, US 10-year real yields have surged to 2.6% from 1.8%, while the global equities’ forward price-to-earnings ratio has jumped to 15.5x from 13.4x. Similarly, global equities are currently trading 7% above their 20-year average. This looks stretched given the deteriorating macro backdrop and the risks highlighted previously. 

Having said that, the recent volatility has created a lot of dispersion in returns, with some sectors and regions trading on more reasonable valuations. This has opened up attractive investment opportunities on a selective basis, which we discuss later in this article.

Earnings could also be challenged  

At the index level, earnings expectations for next year remain optimistic. Based on an International Brokers’ Estimate System (IBES) consensus, bottom-up analysts expect corporate profits to grow by 11% globally in 2024, vs. 0% in 2023. However, here again significant differences exist at the regional level, with earnings projected to grow by 12% in the US, 7% in Europe, 6% in the UK, 8% in Japan, and 19% in emerging markets. 

In that sense, upcoming reporting seasons will be closely watched, with investors paying particular attention to trading outlooks and management guidance for the year ahead. Key areas of focus include any signs of weakening demand, pricing power, the impact of higher rates on borrowing costs and delinquency rates, the availability of credit, as well as the impact of a potential oil shock on earnings.  

However, over the medium to long term, equities still offer attractive return prospects 

While the risk / reward proposition for equity markets looks challenging in the near term, the longer- term picture is more encouraging, 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. These returns are essentially in line with the returns posted in the past two decades, and well above US 10-year Treasury yields of 4.8% at present.

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 over the subsequent 10 years, including dividends

What does this mean for investor positioning?

Staying invested

With that in mind, and given the difficulty in timing markets, staying invested remains preferable but investors would do well to consider downside protection and a more defensive positioning. Indeed, with many risks on the horizon, capital preservation should be the number one focus. To that end, option strategies may be particularly useful in the current environment, allowing to both mitigate downside risk in portfolios and enhance risk-adjusted returns.

Diversification to the rescue

In addition, diversification within and across asset classes is more important than ever. In particular, investors could consider adding exposure to alternative asset classes (subject to personal circumstances), including private markets and hedge funds, as they can bring uncorrelated sources of returns and less directional exposure to equity markets, respectively.

A defensive but balanced positioning 

Within the equity market, a more defensive but balanced positioning appears warranted, at least in the short term. Indeed, some areas of the market remain attractive for investors who can tolerate short-term volatility.

With global growth expected to slow and yields expected to normalise over the course of next year, some sectors appear better positioned than others, namely the defensives and bond proxies.  

The chart below ranks global sectors’ relative performance according to their correlation with US 10-year Treasury yields as of March 2022, i.e. before the start of the aggressive monetary policy tightening cycle by the US Federal Reserve. We have excluded the past 18 months from our analysis, as the correlation between equities and bond yields has substantially weakened over this period (from positive to negative). But as inflation moderates, we expect the typical relationships of the 2000-2022 period to re-establish themselves. 

At the bottom of this chart, utilities, consumer staples, telecom and healthcare sectors rank as the most negatively correlated with yields globally. In other words, they tend to outperform the market, as yields decline. These sectors also rank as some of the most defensive ones, as they generally outperform the market in periods of weaker economic activity. 

The sectors most negatively correlated with yields look best positioned to outperform, as yields decline

Correlation of global sectors' relative performance vs US 10-year Treasury yields as of 01/03/2022 (6-month changes over 10 years) 

Utilities, consumer staples and energy look well positioned

Taking valuations into account, out of those four sectors we favour utilities and consumer staples, which have substantially de-rated in recent months, as interest rates have surged. Based on MSCI All Country World indices and forward price-to-earnings multiples, utilities and consumer staples trade at a significant discount to their 10-year average (2.2x and 1.7x standard deviations below 10-year average, respectively), near historical lows. They offer a superior forward dividend yield (4.5% for utilities and 3.0% for consumer staples, versus the market on 2.3%). Their earnings expectations for 2024 also look more conservative and less prone to disappointment.

Within the more cyclical sectors, we remain positive on the global energy sector, despite a 14% outperformance since mid-July. The sector is still lagging its relationship with earnings, and it is well positioned to benefit from higher oil prices. The sector continues to look cheap, trading at a significant discount to history (0.9 standard deviations below its 10-year average), with a superior forward dividend yield of 4.1%. It also represents an attractive hedge against an oil shock, inflation more generally, and geopolitical risk.

UK equities remain attractive 

At the regional level, we also favour the more defensive markets, which trade at a discount to history. On that basis, we continue to like large-cap UK equities, which have a defensive tilt and are overweight consumer staples and utilities amongst others, and tend to outperform global equities in a down market. UK equities currently trade at 10.4 times forward earnings, a 26% discount to their 10-year average, and offer one of the highest dividend yields amongst major markets (4.5% forward dividend yield).

Other markets, such as the Eurozone and China, also screen cheap. However, they are more cyclical and appear more vulnerable to a growth slowdown. In the absence of a catalyst, they are unlikely to re-rate in our view. 

The bottom line

2024 is likely to be another challenging year for equity investors. While the long-term picture remains bright, the short-term outlook is clouded by elevated uncertainty and demanding valuations. Opportunities are much more likely to materialise at the sector and stock levels rather than at the index level. To best navigate this uncertain backdrop, investors will need to be creative while remaining laser-focused on their long-term goals.