A time for selectivity and quality amid shifting tides

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

• Equity markets have thrived, but growth moderation demands a selective focus on quality.
• Broadening market leadership offers opportunities beyond Big Tech and index-driven rallies.
• Elevated valuations mean disciplined investment selection is essential for sustainable returns.
• As economic and (geo)political uncertainties persist, diversifying across sectors and defensive positioning remain key.

Warren Buffett once said: “It’s only when the tide goes out that you learn who’s been swimming naked.” In today’s market, this serves as a reminder of the importance of resilience and strong business fundamentals as investors navigate a slowing economy and uncertain world.

Looking ahead, it’s essential to recognise that, while equity markets have been fuelled by the strong performance of a select group of high-growth, mega-cap tech companies, diversification and quality across all sectors remain key to enduring returns.

This year, we recommend looking beyond index-driven rallies to focus on quality companies that can deliver growth as the economy moderates and trade at reasonable valuations. By emphasising these attributes, one can identify opportunities in a market where disciplined stock selection is increasingly crucial, allowing an investor to capitalise on a more diverse range of sectors as the market broadens.

Equity indices are back near all-time highs...

With regards to 2024, it’s been another good year for global equities, though progress has not been linear. Despite an 8% correction in the summer, which was quickly reversed, the MSCI All Country World Index is up 17% year-to-date at the time of writing, and 54% above its October 2022 lows. 

This performance reflects (i) improved growth and inflation expectations globally, (ii) continued enthusiasm around the long-term impact of artificial intelligence (AI) on the economy, and (iii) the anticipation of a significant easing in monetary conditions in major economies.  

... but a lot has changed under the surface

The summer sell-off was accompanied by a notable change in market leadership, as fears of a growth shock resurfaced. As in typical market sell-offs, the areas that had performed most strongly since the October lows were the ones which corrected the most. Capital flowed out of Big Tech into the rest of the market, with ‘value’ equities outperforming their ‘growth’ peers. Small caps outperformed large caps (especially in the US), defensive sectors beat cyclical ones, and low volatility stocks outpaced the rest of the market. 
 
Since then, global equities have retraced their losses and made new highs, driven by improved economic data, receding fears of a growth shock, and investors’ attention shifting back to central banks’ easing. However, the leadership changes mentioned above have only partially reversed (see chart).

The great rotation

The brutal equity market rotation that accompanied the summer sell-off has only partially reversed, despite equities back near all-time highs

While equity markets remain highly concentrated, the recent broadening of market leadership is a welcome development. Encouragingly, 45% of S&P 500 companies have outperformed their index over the past six months, a significant improvement from just 20% in mid-July. Market breadth has also improved in Europe, with 52% of STOXX 600 stocks outperforming their index, compared to 38% in late June.

Where do we stand today?

Following the rally, global equity valuations look stretched by historical standards, seemingly discounting very little risk of a weakening in economic conditions. Global equities trade at 18.2 times forward earnings, 25% above their 20-year average, largely driven by the tech-heavy US market. In contrast, European shares trade broadly in line with their long-term average, while UK equities trade at a 5% discount (see chart).

Equity valuations vary significantly across regions

Price to earnings (PE) multiples look stretched by historical standards in the US, but more reasonable in Europe and the UK

At the same time, analysts expect companies to grow earnings by 9% globally in 2024, and 13% in 2025. These estimates seem high, based on our macroeconomic outlook, and leave little room for disappointment. Our economists anticipate global gross domestic product (GDP) growth to slow to 3.0% in 2025, down from 3.2% in 2024. Historically, this level of economic expansion, which is slightly below the long-term trend, has coincided with flattish earnings growth.

Finally, investor sentiment is no longer depressed, as it was back in October 2022, when only a small piece of good news was needed to trigger a rally.

Where do markets go from here?

Ultimately, market direction will depend on the economic growth trajectory (and whether a recession is avoided) and the sustainability of the AI theme that has driven markets in the past couple of years. As discussed in The Great Unwind key indicators to monitor will be the US labour market and corporate earnings.

Companies will need to deliver on high earnings expectations

The 35% rally in global equity prices since October 2023 has been primarily driven by valuation expansion, based on the MSCI All Country World index. Corporate earnings reported during this period have risen by only 6%, while PE multiples have jumped by 27%, on the expectation of solid earnings growth in the future. 

With valuations unlikely to expand much from current levels, future equity market gains rely on companies’ ability to deliver strong profit growth, amid a highly uncertain economic and geopolitical backdrop. The good news is that expectations (and valuations) aren’t necessarily excessive across the board.

In the near-term, volatility is likely to prevail ...

With significant uncertainty around (geo)politics, the health of the US labour market, and ultimately, the path for interest rates, volatility is likely in the coming months. Corrections and sharp rotations within the equity market, similar to that seen in mid-2024, are possible. However, these could be seen as possible entry points.

... but over the longer term, further outperformance can be expected

Indeed, global equities should continue to outperform bonds over the long term. While simple valuation metrics are not effective for timing investments, cyclically-adjusted PE ratios (CAPEs) have historically been reliable indicators of long-term returns. 

At current levels, CAPEs suggest that global equities could return 6.4% annualised over the next decade (including dividends), with significant contributions from non-US markets. While this is below the 9.0% annualised returns of the past decade, it remains more attractive than the 4.3% yield currently offered by US 10-year Treasuries.

In that context, diversification and prudent risk management are crucial

In this environment, maintaining a well-diversified portfolio across sectors, regions, and styles is essential for equity investors. With returns likely to be more muted going forward, a greater focus on yield generation and capital protection is essential. Option strategies and structured products can be useful tools in that respect.

Within equity portfolios, a selective approach and defensive positioning are warranted

Given demanding valuations at the index level, selectivity is key. Most opportunities are likely to materialise under the surface, at the stock level or within specific sectors or geographies.

1.  Favour quality stocks: At this stage of the cycle, we favour quality companies with strong balance sheets, that have shown resilience in previous downturns and trade at reasonable prices.

2. Prefer equally weighted over market cap weighted indices: For investors who need to maintain index-level allocations, we would lean towards equally weighted indices. Indeed, the equally weighted MSCI All World Country index trades in line with its 20-year average, based on forward PEs, while its market cap-weighted counterpart is at a 25% premium.

3.  Favour defensive sectors and “bond proxies”: With global growth projected to slow below trend in the next couple of years and yields expected to decline, defensive sectors and so-called bond proxies could help to improve portfolio diversification. In previous easing cycles over the past 50 years, defensive sectors consistently outperformed cyclicals, regardless of whether the economy entered a recession, as flagged in “The economy matters more than the Fed” (albeit past performance is never a guarantee of future performance).  This aligns with the US central bank cutting rates in response to a decelerating economy.

Notably, the performance of cyclicals versus defensives in the past year has remained resilient despite the weakness in the global manufacturing cycle, and the underperformance of industrial metals versus precious metals (see charts). Historically, defensive sectors have tended to outperform in such environments.

Cyclical equities have been resilient relative to defensives, despite ongoing weakness in the manufacturing sector

Relative 12-month performance of global cyclicals vs defensives against the ISM Manufacturing index

The relative performance of cyclical sectors vs defensives has also been at odds with internal price dynamics within the commodity complex

Historically, the outperformance of precious metals against industrial metals has tended to coincide with defensive sectors outperforming their cyclical peers

At the sector level, utilities and consumer staples appear best positioned globally, being negatively correlated with the business cycle and interest rates. They remain reasonably priced, especially in Europe, despite a significant rerating over the past year, and offer superior dividend yields. Additionally, more conservative earnings expectations offer less room for disappointment.

4. Maintain some exposure to deep value cyclicals as an upside hedge: In light of all the uncertainty, we recognise the need to account for scenarios that fall outside of our base case. With that in mind, there seems to be merit in maintaining some exposure to deep-value cyclicals that lagged in the recent rally. 

To that end, energy stocks look particularly attractive, trading at steep discounts historically and offering the best dividend yields among 11 sectors (4.1% forward dividend yield versus 1.9% for the MSCI All Country World Index), as classified by the Global Industry Classification Standard. This sector can also serve as a hedge against geopolitical tensions, rising oil prices, and inflation.

5. Regional preferences: We maintain a favourable view on UK large caps, due to their defensive tilt, undemanding valuations and attractive dividend yield. The FTSE 100 index has low exposure to the technology sector compared to global equity indices, making it a compelling option to capitalise on a broadening of market leadership.

Beyond the UK, Chinese shares may become investible again in the coming months, once clarity on the stimulus measures announced by the authorities in September emerges. The proposed initiatives were initially met with a 40% surge in the MSCI China index, but the rally subsequently faded as investors curbed their enthusiasm.  Chinese shares remain attractively valued and largely overlooked, positioning them for a sharp rebound if fiscal stimulus finally starts working.

6. Thematic investing can also be considered: The election of Donald Trump raises the possibility of an increased focus on deregulation and less stringent antitrust laws. This could be positive for profit margins, but also for merger-and-acquisition activity. Separately, if new US tariffs are implemented on Chinese imports, this should benefit companies exposed to the onshoring of US supply chains. In any case, investors should consider a variety of strategies to better tackle a dynamic macro and micro landscape.