Stay defensive and focus on ‘alpha’ 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. 

All data referenced in this article is sourced from LSEG Datastream unless otherwise stated, and is accurate at the time of publishing.

Key points

• Global equities have continued to march higher this year, unphased by rising yields and heightened geopolitical tensions. They are now back to all-time highs, 26% above their October lows.  
• While the debate has shifted drastically from fears of a ‘hard landing’ of the economy last year, to hopes of a ‘soft landing’ or even a ‘no-landing’ this year, the market seems to be positioned for the most optimistic outcome. This does not leave much room for disappointment on the growth or inflation front.
• While the upside potential looks limited at the index level, ‘alpha’ opportunities can still be found under the surface. As the economy slows and vulnerabilities are exposed, investors are likely to become more discriminating in the coming months. A renewed focus on company fundamentals should help unlock undervalued assets.
• This article explores areas of the markets, which appear best positioned in the current environment. At this stage of the cycle, and given the level of uncertainty, a defensive tilt in portfolios seems warranted, alongside selective exposure to deep-value cyclicals.

Global equities have continued to march higher this year, unphased by rising yields and heightened geopolitical tensions. Apart from a 5% pullback in early April, which was quickly reversed, stock markets have gone up almost in a straight line. They are now back to all-time highs, 26% above their October lows.  

Context behind the recent rally and performance drivers

The strong performance of equities in 2024 is remarkable, considering the sharp repricing in rate expectations in recent months. At the start of the year, the market was pricing in six or seven US rate cuts in 2024. But following higher-than-expected inflation prints, and more hawkish communication by the US Federal Reserve (Fed), those expectations have been slashed, with the market now expecting only one or two cuts this year. Over this period, US 10-year yields have jumped from 3.8% in December to 4.4% at the time of writing.

The rally has been driven primarily by re-rated valuations, in anticipation of improved earnings momentum. Although some regions appear to be more expensive than others, global equity valuations are elevated by historical standards, trading at 17.6 times their forward earnings, over 20% above their 20-year average. 

Those valuation multiples look vulnerable if the growth/inflation mix deteriorates, which is one of the key risks the market is focusing on at present (see chart). This means that a significant increase in corporate earnings is now required to justify the recent moves in equity prices, and for the rally to be sustained.  

Equity valuations tend to compress with negative growth/inflation surprises

Six-month change in global equities' trailing price-to-earnings ratio, compared with the spread between Citi’s global economic surprise and inflation surprise indicators over the past 20 years

What the market is pricing in

While the debate has shifted drastically from fears of a ‘hard landing’ of the economy at the start of last year, to hopes of a ‘soft landing’ or even a ‘no-landing’ at the beginning of this year, the market seems to be positioned for the most optimistic outcome. Global equity prices appear to be discounting a ‘no-landing’ scenario, where economic activity reaccelerates significantly in the coming months.

Based on historical relationships with business surveys and corporate earnings, global equities are pricing in a strong recovery in the manufacturing cycle, consistent with above-trend gross domestic product (GDP) growth, as well as a 15% to 20% jump in global earnings this year. 

How likely is this scenario?

Equity markets appear overly complacent on the economic outlook. The US manufacturing sector has been in contraction territory for most of the past 19 months. While there were tentative signs of stabilisation during March, those were not sustained in April and May. Similarly, the earnings growth discounted by the market is approximately twice as high as the 8% average growth reported globally over the past 50 years. It is also significantly ahead of analysts’ forecasts of a 10% increase in earnings this year.

In contrast, our base case scenario is more conservative. It assumes a modest slowdown in global growth over the next couple of years, and a normalisation of inflation towards central banks’ targets. We project global GDP growth to decelerate from 3.2% in 2023, to 3.1% in 2024, and 3.0% in 2025 (below trend growth of 3.4% since 1980). We also expect the global rate of inflation to moderate from 3.9% in 2023, to 2.6% in 2024, and 2.4% in 2025. 

Historically, our growth expectations have been consistent with flattish earnings growth globally. This is backed up by the historical relationships with business surveys and bank lending standards.

Uncertainty around the economic outlook

As mentioned previously, the most probable outcome is one where global growth decelerates (but does not collapse), inflation normalises (with bumps along the way) and yields decline.

However, the path for central banks to deliver a ‘soft landing’ is very narrow. If policy rates are kept restrictive for too long, in order to rein in inflation, they could push the economy into a recession. Alternatively, if rates are cut too soon, to protect the economy, inflation could re-accelerate. Both scenarios would be negative for risk assets, and equities in particular. The situation is further complicated by a swathe of elections this year, not least in the US, as well as heightened geopolitical tensions. 

What might this mean for equity portfolio positioning?

While the upside potential for equity markets appears limited at the index level, ‘alpha’ opportunities can still be found at the stock, sector, style and regional levels. 

1. At the stock level

There has been a significant increase in the dispersion of returns in recent months, with investors paying more attention to company fundamentals than macroeconomic drivers. This seems likely to persist, with more differentiation in share price performance expected, particularly during earnings seasons.

At a time of slowing growth, disinflation and elevated interest rates, we would continue to focus on quality companies. That is, those with a high return on equity, solid balance sheets, low financial leverage and stable earnings through the business cycle. Investors need to be selective, as quality companies have outperformed strongly in recent months and now trade at a significant premium to historical levels. The MSCI World Quality index has returned 32% in the past year versus 25% for the broader market. 

Another option is to maintain exposure to structural growth trends, which tend to be less correlated with market moves. Certain themes continue to attract a lot of interest, including the adoption of artificial intelligence within the wider economy, as well as security in its various forms (whether related to cyber, food or defence).

2. At the sector level

At the sector level, we continue to favour the more defensive parts of the economy, which have lagged in the recent rally, and tend to outperform the broader market in periods of slowing growth and declining yields. Amongst those, utility and consumer-staples stocks remain reasonably priced, despite a strong rerating in the case of utilities in the past three months. They trade at a discount to history (especially in Europe), offer a superior dividend yield and analysts’ earnings expectations look conservative.

However, given the high level of economic and political uncertainty, it also makes sense to maintain some exposure to select deep-value cyclicals, which should behave as a hedge if global growth proves to be more resilient than anticipated. 

Global energy stocks are particularly well positioned in that context, as they trade at a deep discount to history, and offer the best dividend yield amongst the 11 Global Industry Classification Standard sectors (4.0% forward dividend yields versus 2.0% for the MSCI All Country World Index). They can also be an attractive hedge against any escalation of geopolitical tensions, rising oil prices and inflation in general.

3. At the regional level

At the regional level, we continue to favour UK stocks for their defensive tilt, undemanding valuations and attractive dividend yield.

We also see a short-term window for eurozone equities to outperform their US peers over the remainder of the year (see chart), although we would be more neutral over a longer investment horizon. Two catalysts should help drive this short period of outperformance:

• The divergence in central bank policies, with the European Central Bank likely to cut rates before the Fed this year;
• A reversal in growth momentum, with economic activity improving from a low base in the eurozone and decelerating from an elevated level in the US.

Eurozone equities tend to outperform their US peers when economic activity in the bloc surprises more positively than in the US

Six-month change in the relative performance of eurozone equities versus US peers in local currency, compared with the difference between Citi’s economic surprise indicator in the eurozone and the US over the last 10 years

Relative valuations are also supportive, with eurozone equities trading at a 36% discount to their US peers, compared with a 21% discount on average in the past 20 years (based on forward price-to-earnings multiples). This is 2.3x standard deviations below the long-run average (see chart).

Eurozone equities trade at a significant discount relative to their US peers

Eurozone equities' valuation discount to US equities, based on forward price-to-earnings ratio, over the past 20 years

In summary

With global growth slowing and equity markets trading at all-time highs, the upside potential looks limited at the index level. Having said that, attractive opportunities still exist, under the surface. As the economy slows and vulnerabilities are exposed, investors are likely to become more discriminating. A renewed focus on company fundamentals should help unlock undervalued assets. At this stage of the cycle, and given the level of uncertainty, a defensive tilt in portfolios seems warranted, alongside selective exposure to deep-value cyclicals