Equities Focus January 2023
Europe and Emerging Markets recover
Equities at a glance: Stay Positive
1.Factors that support our Positive Equities view include a) falling energy prices and inflation rates; b) better-than-expected economic momentum as consumers hold up well; c) a rebound in global liquidity (represented by global M2 money supply), and d) stable to lower long-term real bond yields. To these we can also add attractive valuation levels (compared to history) in World ex-US equities.
2.Stronger momentum in eurozone, UK and Hong Kong stocks in late 2022: the better resilience of earnings estimates in Europe and the UK, plus the historically cheap valuations still on offer (including high and well-backed dividend yields) are key factors for our preference for European stocks, particularly those with a value bias.
3.Favour World ex-US stocks over US, equal-weight within US: we prefer to invest in the UK, eurozone, and Emerging Market regions (including China) given improving economic momentum, low valuations and resilient European earnings forecasts. We remain Neutral on the US, preferring mid-cap and equal-weight equities exposure.
(+) Positive globally on the value factor: growth stocks posted 118% outperformance versus value stocks from 2007 to August 2021. Since then, value has rebounded vs. growth by 32%. But given the scale of the rebound of value against growth from 2000 to 2002, and from 2003 to 2007, we believe value may have a lot further to run. Favour sectors, funds and ETFs focused on value stocks, including higher dividend strategies.
(+)Cash flow-rich value sectors still favoured: we like portfolios based on the value style, comprising a heavy bias to strong cash flows and balance sheets, including the Energy, Financials and Mining sectors.
(+) Precious metals breakout: as gold and platinum lead strong precious metals’ price momentum on declining bond yields + US dollar, focus on gold producers which remain relatively cheap with strong cash flows and balance sheets.
Key Risks: the US Federal Reserve continues to raise interest rates post the February FOMC meeting, triggering a deeper economic slowdown. A larger sell-off in housing markets could weigh on consumption.
1. Equities Outlook
Tilt towards value factor, sectors, world ex-us
The peak in US 2-year bond yields a powerful signal for stocks: following peaks in the 2-year bond yield (driven by US Federal reserve rate policy), global stocks performed strongly in 2006-07 and in 2019. We see a similar stock rally developing in 2023, favouring the Value style and World ex US stocks.
Stay the course with Energy: we believe
that energy prices have an asymmetrical outlook – a much higher probability that they will rise than fall over time, remaining far above long-term averages. We favour the global Oil & Gas and Renewable Energy sectors as well as the Energy Efficiency theme.
Cash flow-rich value sectors still favoured: we like portfolios based on the value style, containing a heavy bias to strong cash flows and balance sheets, given the inherent Energy, Financials and Materials sector bias.
Prefer US mid-caps over large-caps: US mid-caps are much more domestically-focused than large-caps, which is a definite advantage at the moment given the strong US dollar (and the impact on overseas earnings of US large-caps), while US domestic consumption remains strong. US mid-caps still boast robust balance sheets and trade currently at a historically wide 25% P/E discount to the S&P 500.
Peak US dollar to drive World ex-US comeback? A stronger US dollar and a technology stock mania in the late 1990s were the twin motors of US stock outperformance up until 2000. Today, we have seen the same tech mania and US dollar strength trends, notably since 2020. But a peak in the greenback plus an unwinding of tech stock outperformance could drive World ex-US outperformance, as seen in the 2003-07 period. The starting point is a record gap in valuations between US stocks and the World ex-US stock universe. Keep avoiding expensive growth stocks displaying low/disappointing profitability.
2. A torrid 2022 for retail investors
Overexposure to growth stocks hurts retail
The average US retail investor has seen the value of their overall portfolio fall by 35% on average since late 2021, far worse than the performance of the S&P 500 index (-19% since January 2022 including dividends). Furthermore, this is worse than the 30% drawdown experienced at the height of the COVID crash in March 2020 (when investors' portfolios subsequently recovered in record time). This weakness is due to the overexposure of many investors to technology and growth stocks, which have suffered more over the last year or so (in line with the 35% drop in the Nasdaq 100 since end-2021).
Investor sentiment remains very bearish
Despite the latest stock market rally, the poor 2022 performance of retail investor portfolios (both in stocks and bonds) and widespread economic pessimism continue to drag on both professional and retail investor sentiment.
The US AAII investor sentiment survey remains in very bearish territory at the start of 2023, as it has done for most of 2022. In the past, this has acted as a fairly reliable contrarian indicator, suggesting, along with other indicators (such as the put/call option ratio) that investors are not yet participating in the current rally.
3. World ex-US vs US preferred
European equities start to outperform US
European equities dramatically underperformed US equities between 2018 by 40% and late 2022, hurt by higher US profit margins, stronger US earnings growth and a stronger US dollar.
But this US outperformance has reversed in the last few months, just as value has started to recover against growth. Better resilience of 2023 earnings forecasts and a weaker US dollar have been two key factors in this turnaround. Valuation and earnings momentum continue to favour European stocks.
Emerging markets rebound vS US, led by mexico
In the post-COVID pandemic era, emerging market stocks have steadily underperformed the US, largely on the back of pessimism over China. However, with the surprisingly quick relaxation of China’s strict zero COVID policy together with multiple measures to support the Chinese property market, emerging markets have begun to recover relative to the US. Mexico clearly stands out in Emerging Market equities, set to benefit from near-shoring (away from Asia) by US companies which are keen to make their supply chains more robust.
4. US: Equal-weight S&P 500 preferred
Prefer equal-weight S&P 500 exposure
Since the beginning of 2021, the equally-weighted version of the US S&P 500 index has outperformed the classic market-capitalisation weighted version by 15%. This is the return of the long-term trend in favour of the equal-weight index, after an abnormal period from 2018 to late 2020 when the largest stocks outperformed.
Since 2000, the S&P 500 equal-weight index has returned a cumulative 682% (9.3% average per year), outpacing the market cap-weighted S&P 500’s 311% cumulative return (6.3%) by a full 3% per year on average.
US mega-cap tech still trails
Since the beginning of 2022, the largest tech stocks have trailed in the US with a -39% return (for FAANG stocks), while the Nasdaq 100 tech-heavy index returned a poor -29%, after very strong three years from 2019 to 2021.
In contrast, note that the equal-weight S&P 500 index only lost 9% over this period, and is rebounding even though FAANG stocks continue to fall.
We remain cautious of US mega-cap tech stocks, given the ongoing erosion in earnings forecasts and valuations that remain rich at 20x+ prospective P/E.
5. Focus on Value
The pendulum FINALLY swings back to value
Growth the recent winner: from 2016 to 2021, growth stocks outpaced value stocks by a wide margin – from 2009 to December 2022, the MSCI World Growth index grew from 100 to 457, while the MSCI World Value index only grew to 305 (including dividends). This represents the longest phase of growth beating value in the history of these indices, going back as far as 1975.
Over the very long term, value is still ahead: but in spite of this strong showing by growth (largely driven by mega-cap technology stocks), value still leads the overall performance, with USD100 in World Value growing to USD11,146 including dividends, compared with USD7,162 for World Growth.
Value stocks in aggregate still cheap vs. history: one way to judge whether value is still an attractive strategy is to look at valuations of value stocks against history. According to Robeco’s global composite Value index, value stocks are still very cheap compared with their own long-run valuation averages. So value as a factor is still globally cheap today, suggesting superior long-run future returns.
Value is supported by better earnings forecast revisions: over 2022, value stocks and sectors in general have demonstrated stronger trends in earnings revisions than for growth stocks. If anything, analysts have been upgrading earnings estimates for several value sectors such as Banks, Insurance and Energy.
Value is not just Banks and Commodity-related sectors: a breakdown of the MSCI World Enhanced Value index reveals that the biggest value sector weighting is actually to Technology (20%), including certain semiconductor producers. The second-highest sector represented is then Healthcare (14%), predominantly Pharmaceuticals and then Financials (also 14%) led by global banks. This global value index offers a 3.5% dividend yield, while the MSCI Europe Value index offers a very generous 5.9% forward dividend yield.
6. Q4 2022 & 2023 earnings expectations
Consumption resilience will be key
In the US, earnings were under pressure in 2022 (-2.7% y/y is expected for Q4 2022; it would be the first quarter with negative growth since Q3 2020). Consumer confidence indicators remain high due to the full employment prevailing in the US, high levels of savings, and more recently, a fall in energy prices. ‘Mega Tech’ is a black spot (abundant downward earnings revisions). Companies have started laying off staff.
Valuations are rich in the US: the forward P/E is now around 18x. Tech, Consumer Discretionary and Staples Sectors trade at average P/E levels above 20. Industrials and Utilities are also approaching this level. Consumption resilience will be key to determining if earnings can stabilise or if we will enter a deeper recession than the market has priced in. In 2023, the IBES consensus is now +3.7% earnings growth, which is a bit optimistic to us.
Earnings have held UP relatively better in Europe
In 2022, European companies displayed resilience in most sectors. European exporters were helped by the strong USD whereas, the high energy prices did not hurt economic growth or profitability too much.
FY 2022 earnings are set to grow by +18.6% in Europe, but almost zero growth is on the cards for 2023.
As mentioned last month, inflation (and its impact on consumption, profit margins, etc) is key, and its level will depend on how fast governments can find solutions to geopolitical tensions and to the energy crisis. Europe still trades at a cheap forward P/E of around 12x. Some sectors that perform well during inflation times are still very cheap: Energy, Financials, Health Care, but also Materials when taking into consideration China’s potential for recovery.
7. Asian Equities view
•China equities continued another strong upwards move in December as COVID-19 restrictions were significantly loosened in Mainland China. The government issued a 10-point directive which includes allowing people with COVID showing mild or no symptoms to quarantine at home, less frequent mass testing and crucially a focus on boosting vaccinations among the elderly. Cases may peak around the Lunar New Year in late January albeit risks of new variants or extreme health system stress remain.
•In addition, the government’s Central Economic Work Conference in mid-December illustrated that the government would prioritise the economy and boost domestic demand. While repeating that “housing is for living in, not for speculation”, policymakers would support fundamental and upgrading property demand. They are also focused on containing the risks around large property developers.
•We already turned more positive on China equities at a global level in early December. This was based on the potential progress on COVID-policy loosening, more aid to help a bottom in the property market, and the cheap valuations. These further actions have given us the catalysts we had forecasted. Of course, there could be near-term volatility concerning the pace of reopening. We favour policy beneficiaries including consumption recovery stocks in the Travel, Leisure, and Services sectors, and selected companies in the Technology sector.
8. Positive on Banking and Materials
Banks are too cheap!
Cyclicals remain highly discounted versus growth stocks, especially in Europe (see chart below). In addition, unlike many others, some cyclical sectors are seeing upward earnings revisions, particularly Banks.
They benefit from rising interest rates (their own deposits are better remunerated) and bond yields, as well as the unprecedented (in such a short time) widening of net interest margins. Banks’ profits will thus grow significantly in a context in which the recession is expected to be rather mild in the West. As a reminder, following the profound restructuring in recent years, banks’ balance sheets have never been stronger. Many European banks are even buying back their own shares today. Others are experiencing renewed growth in promising businesses, such as Wealth Management and Asset Management.
We have a slight preference for European banks, trading at an average forward price to earnings ratio of 6.8x vs. 9.8x for American banks.
We are therefore now Positive on all financial sub-sectors, including banks.
ASIDE mining, other opportunities EXIST in materials
Commodity stocks are extremely cheap and still very profitable. In 2022, the market focused on the slowdown in the global economy, particularly in China, and on significant cost increases due to supply chain concerns, rising wages, energy, etc. These costs are starting to be much better controlled. Furthermore, China is reopening and boosting its economy. Recently, there has been little investment in new production capacities, which could cause bottlenecks in the medium term.
The Materials sector in general is highly correlated to China and valuations are reasonable. Numerous consolidations and restructurings are taking place in this space (mergers have recently been announced in the chemicals sector). Companies are refocusing and specialising in promising niches, and this in turn is shoring up profit margins. In addition, the energy transition and energy efficiency need increasingly high-performance materials with greater added value. Therefore, in a context in which we believe that the global economy will be resilient in 2023, the Materials sector should outperform.
9. Sector Allocation
Our allocation has been adapted to the resilient economy and to the recovery in China
Our favourite sectors performed very well in 2022. China is now reopening and taking significant measures to stabilise the economy, in particular the troubled real estate sector. Looking beyond the resurgence in COVID cases mainly in China, new opportunities are appearing to play the better outlook in China, including some on the Western stock exchanges.
¡At the same time, the Western economies have been quite resilient. Energy and other costs are now under control. Last December, we upgraded the Materials sector, as it remains relatively cheap and quite correlated with China. The present environment also looks much better for Banks (rising net interest margins, resilient economy). These were also upgraded to Positive in December.
¡Inflation, though receding, is still high and we recommend exposure in sectors that are performing well in this type of environment (Energy, Basic resources, Financials, Health Care). In addition, the complex geopolitical environment still supports our 2023 investment theme of energy efficiency (& transition).
Despite their outperformance in 2022, Energy, Basic resources, Financials, and Health Care are all still cheap. They are expected to record more gains. These sectors, as well as some REITs, perfectly fit in our current Value call.
¡Regarding European REITs, the worst should be behind us; they trade at huge discounts to NAVs and are now trying to recover but the renewed volatility in bonds isn’t helping.
¡We still advise keeping a good chunk of any equity portfolio invested in companies with pricing power. Latest corporate results and forecasts proved once again that this is one of the best segments to be invested in.
¡Secure and rising dividends is another style we like. We recommend Health Care, Insurance, some select Utilities to gain exposure to this style.
¡Richly-valued stocks (mainly in growth/Tech segments) are still vulnerable, especially those displaying disappointing results or forecasts. Be very selective there.