Markets Weekly podcast – 27 November 2023
Equity markets and recession prospects
Equity market special: Following the release of our ‘Outlook 2024’ report, Dorothée Deck, our Cross Asset Strategist, talks us through some of the key challenges and opportunities facing investors over the short, medium and long term. Other topics include global recession prospects, corporate earnings and the role of diversification. While Julien Lafargue explores the health of the manufacturing sector and inflation in the major regions.
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Julien Lafargue (JL): Hello, and welcome to a new edition of Barclays Private Bank’s Markets Weekly podcast. My name is Julien Lafargue, Chief Market Strategist at Barclays Private Bank, and I will be your host today.
As usual, we’ll first go through the events of last week before moving on to our guest segment. And, this week, I’m very pleased to be joined by Dorothée Deck, Cross Asset Class Strategist with us at Barclays Private Bank, to discuss our ‘Outlook 2024’ when it comes to equities, and we have a lot of things to cover.
But let’s first start by looking at the week that was. And, in fairness, it was a fairly uneventful week in the sense that it was a holiday shortened week in the US. I hope our listeners have been able to enjoy Thanksgiving. But, from a market perspective, not much happened. Equity markets continued to grind higher and, really, this happened supported by minimal news flow.
The main macroeconomic datapoints from last week came in the form of November’s preliminary PMIs. So, if we look at it by regions, in the US, manufacturing missed consensus. It printed at 49.4, and it was down from last month’s 50 print. It’s actually the lowest print in three months.
Meanwhile, the services PMI at 50.8 came in slightly better than expected, and it was up slightly against the previous reading, registering the highest print in four months. So, a positive picture on the services side, more mixed on the manufacturing side.
Now, if we move on to the eurozone, the composite PMI climbed by 0.6 points to 47.1, beating expectations of a more muted increase. Similarly, a 1.4-point increase in the UK composite pushed it to 50.1, following three consecutive months of reading below 50, the famous boom-bust line.
But that was pretty much of it from a macroeconomic standpoint last week. Again, very, very quiet, which is good news because it’s going to give us plenty of time to discuss equity markets for 2024 with Dorothée.
So, Dorothée, thanks again for joining us today on the podcast. Obviously, I have a few questions for you. Maybe we can start by taking a step back and look at where we came from.
Equity markets have been very, very resilient in the past year, probably more resilient than many people had expected. Were you, yourself, surprised by the strength of the rally, and maybe can you can share some colours to, you know, what was behind that strength?
Dorothée Deck (DD): Hi, Julien. Yes, absolutely, we’ve seen very significant moves. So, global equities are now up 26% from their lows in October last year, and only 2% below their summer highs. I think a lot of people have been surprised given the weak macro backdrop we had at the start of the year.
So, back in January, close to 70% of the economists were expecting a recession in the US at some point in 2023, and as much as 80% in the eurozone, and 90% in the UK. So, the most anticipated recession has failed to materialise. Growth has generally been more resilient than expected, especially in the US.
I guess people underestimated the strength of the consumer, and they overestimated the time it takes for monetary policy to impact the real economy. As it is often mentioned, monetary policy impacts the real economy with long and variable lags, and it is always difficult to time the next recession. But I would say it’s even more difficult in the current environment because the pandemic has distorted a lot of the typical relationships you normally see within the economy and between the economy and financial markets.
This means that we cannot rely on the old playbook to make predictions today with the same level of confidence as in the past. Now, besides the resilience in the economy, markets have also been fuelled by expectations of a peak in rates and the AI frenzy. Clearly, the timing and magnitude of the rate cuts anticipated by the markets has varied a lot lately but, as of today, markets are expecting roughly 100 basis points of rate cuts in the US by January 2025.
With regards to the hype around artificial intelligence and its long term impact on the economy, it has led to a very high degree of concentration in the market, especially in the US, which raises concerns over the sustainability of this rally. And I’ll give you a few numbers to illustrate that point.
So, year to date, the S&P 500 is up almost 20% and it’s been led by a very small number of stocks mainly mega cap names in tech-related industries. So, if you look at it on an equally weighted basis, the average stock in the S&P is essentially flat. Over the same period, the tech heavy Nasdaq 100 index is up close to 50%, while the FANG+ index is up a staggering 90%.
But, if I had to pick only one number to illustrate that point, I would say that in the past year only 27% of the S&P 500 companies have outperformed their index. That’s a record low, only matched twice in the past 50 years, back in 1987 and back in 2000, periods that were followed by significant market sell-offs. And that’s why I believe that market concentration in the US today is a concern. However, I should note that outside the US, the market is not as concentrated.
JL: It’s been quite a challenging year, I guess, for active managers, at least those who are on the right side, probably very rewarding if you were positioned properly, but challenging to be positioned the right way in order to benefit from this rather concentrated rally.
All right, cool. So, that was for the year that was almost. We’re getting very close to the end of the year. Now, let’s focus a bit, if you don’t mind, on the 2024 outlook and looking into next year. Where do you see maybe the greatest risk and opportunity? In other words, what do you think could drive equity markets going forward?
DD: So, I think that going into next year, equity markets face a challenging environment due to a deteriorating risk picture, combined with elevated yields and heightened geopolitical tensions.
So, if I start with growth, it’s been more resilient than expected so far this year, but it’s expected to slow over the coming months.
The US economy has been supported by large excess savings accumulated during the pandemic, a tight labour market, and healthy corporate balance sheets. However, those excess savings are being depleted. We’re starting to see a softening in the labour market, and default rates have started to rise.
In the past couple of years, we’ve had one of the most aggressive monetary policy tightening in history, so we have yet to see the full impact of it on the real economy.
So, the recession that most economists were expecting this year is likely to materialise at some point in the next few months. The implication for risk assets in general will depend on the shape and the severity of this downturn. But the good news is that our economists do not anticipate a severe downturn because of the absence of major imbalances in the system at present.
With regards to yields, they’re likely to remain elevated for an extended period of time, and probably for longer than the market expects, which will put pressure on equity valuations. Yields have been very volatile in recent weeks, and they have been responsible for the sharp moves in equities.
So, we’ve seen a 10% correction from the beginning of August to the end of October, which has now been almost fully reversed. So, generally speaking, I think yields will continue to be a significant driver of equity performance at the index level and under the surface at the sector level.
And, finally, with regards to political and geopolitical risks, they’re likely to remain a major source of volatility for markets in the coming year. We have wars in Ukraine and the Middle East with potential implications for the oil price and, hence, global growth in inflation. We have ongoing trade tensions between China, the US and Europe. And, finally, we also have 45% of the world population that will have an election next year, notably in the US, UK, Europe, Taiwan and India.
JL: So, right, the equity markets looking into next year clearly faces a few key challenges, right? Now, it’s always important to try and figure out, you know, to recognise the risk, of course, but then to try and figure out whether the market has sort-of priced them in properly, not properly, if there’s any divergence there. What do you think? Do you think those risks are already reflecting in the price?
DD: Well, after the strong rally, we think that equity markets look complacent and disconnected from the underlying macro fundamentals. So, valuations look stretched given where we are in this cycle and the substantial increase in real yields. And corporate profits are likely to disappoint over optimistic expectations in our view.
If we look at historical relationships, 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. That would be consistent with a no-lending scenario, which is possible but unlikely.
Other indicators we track, which tend to lead earnings growth by six to nine months, actually suggest that global earnings are more likely to contract over this timeframe. So, unless we see a sharp reacceleration in economic activity and a rebound in corporate profits, equity markets look vulnerable to the downside in the near term.
JL: And, you know, I want to stress the fact that these are views that we would apply at the index level, right? Then within the index, sectors and stocks in particular could behave very, very differently.
But, you know, building on this sort of near-term outlook, which I think is fair to describe as somewhat challenging, what about the medium to long term? Do you feel a bit more optimistic about what’s in store for equities?
DD: Yes, we do, and so that’s a key point for investors obviously. The long term prospects actually look much more encouraging with stocks likely to outperform bonds meaningfully over a 10-year investment horizon. So, when we try to assess equities’ long-term return potential, we like to use cyclically adjusted P/Es or price to earnings ratios. Simple P/Es on their own are not are a good timing tool, but cyclically adjusted P/Es have been reliable indicators of long term returns in the past.
And, at current levels, those ratios suggest that global equities could generate annualised returns of 8% in the next 10 years, including dividends. So, that’s essentially in line with the returns that we’ve seen in the past 20 years, and it’s also well above US 10-year yields of 4.5% at present.
JL: Ah, great. So, we talked about the short-term outlook. We talked about the relatively more constructive medium- to long-term outlook. We talked about the fact that, you know, at the index level at least, the next few months could be challenging for equities. So, how do you think investors should be positioned there?
DD: Well, given the level of risk and uncertainty combined with the stretched valuations, it makes sense for investors to be more defensive in their positioning and focus on capital preservation as opposed to capital appreciation.
And, on that point, option strategies can be particularly useful in the current environment to mitigate downside risk in portfolios and, hence, risk-adjusted returns. Interestingly, as markets have rallied, the demand for hedging strategies has come down sharply in recent weeks, and the cost to protect against a market sell-off has now fallen to record lows based on data going back 10 years.
Multi-asset investors should consider increasing allocations to fixed income markets, which offer an attractive alternative to equities at the current time based on relative valuations. The global equity risk premium is at the lowest it’s been since the global financial crisis. Investors should also increase diversification across traditional and alternative asset classes and look for uncorrelated sources of returns.
Now, within equity portfolios, the environment is not easy because most of the indices have run ahead of macro fundamentals. However, the recent volatility has created a lot of dispersion in returns, with some pockets of the markets now trading on more reasonable valuations. And this has opened up attractive investment opportunities on a selective basis at the sector level and the regional level.
So, the key for investors today is to be more selective and opportunistic while staying diversified across sectors, factors and geographies.
JL: Yeah, and I think that’s a very essential point, right, is the point that, again, although at the headline level, the outlook might look a bit challenging, it doesn’t mean there are no opportunities out there. In fact, there are a lot of opportunities if you can position rightly. So, which areas of the market look most attractive to you at present?
DD: So, given our macro outlook of growth slowing down and yields expected to decline over the course of next year, we would focus on defensive sectors and bond proxies. Now, when we take valuations into account, two sectors actually stand out as being well positioned globally. That’s utilities and consumer staples. They tend to outperform the broader market in periods of economic slowdown and declining yields, and they have substantially de-rated in recent months following the surge in interest rates.
Those sectors are now trading at a significant discount to their long average, close to their historical lows, and they offer a superior dividend yield. They also exhibit more conservative earnings expectations for next year, which makes them less vulnerable to disappointment.
Now, we mentioned earlier that it is important to remain diversified across sectors, so within the more cyclical sectors we actually remain positive on the energy sector globally. The sector continues to look cheap, trading at a steep discount to historical levels.
Out of the 11 sectors in the GICS classification, it offers the highest dividend yield at 4.5% for the next 12 months. It also represents an attractive hedge against a potential oil shock, inflation more generally, and geopolitical risk.
Now, at the regional level, we also favour the more defensive markets, which trade at a discount to history and, on that basis, we continue to look to like large cap UK equities, which have a defensive tilt and tend to outperform global equities in a down market. They currently trade at a 30% discount to their 10-year average, and they offer one of the highest dividend yields amongst the major developed markets, 4.6% for dividend yields.
JL: OK, great. So, I guess if I recap what you just said, outside of your sort-of core exposure, where do you see opportunities right now? We saw opportunities in bond proxies. So that would be your, well, utilities, staples, some also potential within the energy space, that’s at the sector level. And, if we look regionally, one market that is going relatively cheap, or very cheap, is the UK market, which could be a good place to hide, so to speak, until we wait for some clarity on the macro side.
Now, that was at the sector level. If we take it deeper and one level down and we focus at the stock level, which is where we said we see most opportunities, what type of characteristic would you be looking for if you were to invest in single stocks?
DD: Yeah, so at the stock level we would focus on quality stocks which have, historically, been more resilient in periods of economic slowdown. So, we’d be looking for companies with strong balance sheets, visible revenue streams, strong and stable margins across the business cycle, and high returns on equities.
Those names as a group are already trading on expensive valuations, so investors will have to be selective and focus on the ones that trade on reasonable valuations given the level of growth they can generate.
JL: Excellent. Well, we covered a lot but that was, you know, very interesting. Thank you so much, Dorothée. And for me, really, the main takeaway is the point that you want to be selective as you go into 2024. You mentioned at the beginning how concentrated the rally was and, you know, a lot of people are mentioning how the Magnificent Seven have contributed to the overall rally.
But the reality is, actually, if you look at the top 10 performers in the US, only three of those 10 are part of those Magnificent Seven. You know, you have stocks that have more than doubled this year that are not part of the broadly defined tech space, so there are really true opportunities, but you need to be extremely selective.
Right. So, before we conclude, a quick look at what’s on the agenda for the week ahead. A bit more busy, which is not going to be hard, but things that we are going to pay attention to, we’re going to get some inflation data from Germany, that’s on Wednesday. The Fed Beige Book will also hit Wednesday.
And then we’re going to be look at the NBS PMI from China. We know that we’re trying to figure out if China has bottomed or not. So, that will be a clear indication that will come on Thursday, followed by a very important eurozone CPI print for the month of November, that same day, as well as the US PCE for October, which the PCE remains the Fed’s preferred measure of inflation.
We’re going to have the delayed OPEC+ meeting, also on Thursday. And, we’ll wrap up the week with the US manufacturing ISM for the month of November. So, again, quite a few things to look forward to and that we will be debriefing next week.
Now, with that, time to conclude. Thanks again. And, as usual, we wish you the very best in the trading week ahead.
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