#Articles — 22.11.2022

Equities Focus November

Edmund Shing, Global Chief Invesment Officer & Alain Gerard, Senior Investment Advisor, Equities

Improving conditions

Equities at a glance

Key Points

1.Over the last month, the 4 key factors we monitor to drive our global equities view have all improved, some quite considerably: financial conditions (looser), real yields (lower), US dollar (lower) and aggregate liquidity (higher).

2.Lower valuations = higher long-term returns: Most segments of the global stock market are cheap today relative to their own long-term valuation history. Europe, Japan, China and US mid- and small-caps all trade today between 10% and 24% cheap to their own 10-year averages in P/E ratio terms. However, US mega-cap tech remains on the expensive side even after correcting.

3.Not all is supportive for stocks, short-term… Earnings estimates are falling in Europe, the US and in Emerging Markets. We expect earnings estimates to fall further as company guidance deteriorates as we enter recession in Europe and in the US.

4.Euro STOXX 50 index is currently overbought: we would expect consolidation in this upwards trend in the very short term, which could then offer a better entry point with higher conviction. We remain neutral on equities overall, for now.

 

Key recommendations

(+) Energy Producers
Overweight sectors providing a hedge against high inflation. European sanctions against Russia (embargo on Russian oil to start in December) and the recently-announced 2 million barrel/day OPEC+ production cut support the sector. This very profitable sector is still extremely cheap.

(+) UK, Japan, Share Buyback + High Dividend equities
UK: energy exposure, cheap with currency benefit, high yields.


Japan: the Japanese TOPIX index is enjoying a good momentum, supported by the weak yen. Valuations are still low whereas earnings growth has been rather good.

Key Risks: still no pivot yet from the US Federal Reserve, as US inflation has not declined sharply. The ISM manufacturing survey looks set to dip below 50 to follow the Markit composite PMI, which has typically been a drag on US corporate earnings.

 

Conditions are improving for stock markets

Over the last month, the 4 key factors we monitor to drive our global equities view have all improved, some quite considerably:

1.Financial conditions have loosened: these conditions are an aggregate of volatility (lower), credit spreads (tighter) and liquidity measures such as the TED spread (tighter). In both the US and Europe, these conditions have turned more favourable for the outlook for stocks.

2.Long-term real yields are falling: 10-year bond yields have eased globally on the back of the latest US inflation prints which have come in lower than expected. We further look for US inflation to decline rapidly over the months ahead; given leading indicators for housing, goods prices and employment.

3.The US dollar is finally weakening: following lower US CPI and PPI inflation prints, market expectations for the US Federal Reserve’s terminal rate has fallen under 5% (expected in January 2023). This has weakened support for the US dollar. In the past, a weaker dollar has typically been good news for risk assets such as stocks, and particularly for emerging market assets.

4.Aggregate liquidity is finally improving: broad global M2 money supply growth has been falling sharply since early this year, reflecting the tightening bias of central banks after years of ultra-easy liquidity conditions. But of late, this liquidity has improved as central banks, led by the People’s Bank of China and the Bank of England, have boosted money supply.

In addition, note that near-term economic momentum, in the form of economic surprise indices, have also entered positive territory since late September, led by the eurozone and the UK. 

Lower valuations = higher long-term returns

Europe, US small/mid, and Japan are cheap

Most segments of the global stock market are cheap today relative to their own long-term valuation history. Europe, Japan, China and US mid- and small-caps all trade today between 10% and 24% discount to their own 10-year averages in P/E ratio terms. Short-term, this reflects the uncertainty around earnings forecasts.

Remember that on a 5-10 year investment horizon, stock market valuations are a good guide to expected returns. So; cheap Eurozone, UK, Emerging Markets and US mid-/small-cap stock indices implies higher long-term returns from here.

While US large-cap tech still expensive…

Large-cap US tech stocks in general disappointed investors over the Q3 results season, with only Apple really beating estimates. Lower profit margins and slower growth are reflected in lower Nasdaq 100 earnings forecasts. But these forecasts could fall further as margins come under further pressure in the quarters ahead.

At the same time, large-cap US tech remains relatively expensive at 21x forecast PE, versus a 2015-2020 range of 16-20x. 

 

3. Not all is supportive for stocks, short term…

Recession means a WEAKER earnings outlook

In aggregate, earnings estimates are falling in Europe, the US and Emerging Markets. We expect earnings estimates to decline further as company guidance deteriorates on the eve of a recession in Europe and in the US. This clearly undermines the argument for US and Emerging Market equities in particular, although further weakness in the US dollar may begin to support the earnings outlook in these regions. Look for earnings forecasts to fall in consumer cyclical sectors in the near term.

European stocks already overbought, near term

In the very short term, it is clear that stock markets have already rallied quite a way since the October lows. The Euro STOXX 50 reference index (see below) has entered an overbought zone (a reading of above 70 on the Relative Strength Index) for the first time this year.

We would expect some consolidation in this upward price momentum in the very short term, which could then offer a better entry point with higher conviction. 

Fed pressure is intense: Pausing soon?

Central banks have tightened policy a lot already

At first glance, today’s Fed Funds rate of 4.0% might not seem all that high, given current elevated inflation levels. However, once we add the effects of much higher interest rates on mortgages and corporate borrowing plus the additional effects of reduced liquidity via the Fed’s Quantitative Tightening policy,  we can see that the “proxy” Fed Funds rate (according to the San Francisco Fed) in fact today already exceeds 5%, a level last seen in 2008. This proxy Fed rate has not been significantly higher than 5% for any length of time since the early 1990s.

Watch leading sectors for market momentum

The key global semiconductor, banks and biotech sectors are developing into new leaders for stock markets worldwide. They have all rebounded strongly and broken pre-existing downtrends since early October. These relatively risky sectors need to maintain this upwards momentum if stocks overall are to develop a new bull market, rather than just a short-term bear market rally. 

Q3 earnings & forecasts

A mixed bag in the us; big tech disappoints

Most S&P500 companies have now reported their Q3 earnings. Revenues are growing a bit more than +10% compared with last year (slightly better than expected). Earnings have also been slightly above (revised lower) expectations, with a growth of +3% ‘only’, compared with Q3 2021. Quite disappointing. New forecasts in the ‘Mega Tech’ sphere shocked the markets in some cases. Margins are under pressure (higher wages & costs, strong USD, etc).

Valuations are still rich in the US: after the October rally, the forward P/E is 17. Tech, consumer discretionary and staples sectors still trade at average P/E levels above 20. Downward revisions still abound, especially in the tech sector.

Consumption resilience will be key to determining if earnings can stabilise or if we will enter a deeper recession than what the market has priced in. 

Earnings ARE relatively better in Europe

Now that more than 80% of European companies have reported their results, we note relative strength in most sectors. Revenues and earnings have beaten forecasts by slightly more than 4% on average. European exporters have been helped by the strong USD whereas so far high energy prices have not damaged profitability too much. In 2022 earnings are set to grow by +18% in Europe but almost zero growth is on the cards for 2023. As mentioned last month, inflation is key, which level will depend on how fast governments can find solutions to geopolitical tensions and to the energy crisis. After the Oct/Nov rally, Europe still trades at a cheap forward P/E, at slightly under 12. Some sectors that perform well during inflation times are very cheap: Energy, Financials, but also Health Care. These (favourite) sectors are enjoying upward earnings revisions. 

 

Sector allocation

No rush to add beta WHEN THE global economy is slowing down; accumulate with selectivity

Q3 corporate earnings season has been very supportive of our sector preferences. Energy, Health Care and Financials have in general reported strong results. On the other hand, there were big disappointments in the US ‘Mega Tech’, Social Networks and Consumer Discretionary sectors. 

¡Momentum, earnings and valuations are still very supportive to Energy, some Metals & Mining (preference for those related to energy and the energy transition), Health Care and Financials. These sectors also tend to perform better in times of high inflation and higher rates/bond yields. 

¡European sanctions against Russia (embargoes on Russian oil to start in December) and OPEC+ cutting their production support Energy in general. This very profitable sector is still extremely cheap.

¡Following the sharp corrections this year, we recommend repositioning on the energy transition & efficiency theme, which are very important in view of the global environment.  

We still recommend keeping a good portion of any equity portfolio invested in companies with pricing power and/or returning big amounts of cash to shareholders. Among defensive sectors, we still prefer Health Care. 

¡Regarding European REITs, we believe that the worst is behind us (as we consider that bond yields have peaked); they trade at huge discounts to NAVs.

¡We still recommend keeping a good chunk of any equity portfolio invested in companies with pricing power. Q3 results and forecasts prove once again that this is one of the best segments to be invested in this year. Secure and rising dividends are another style we like.

¡On the other hand, cyclical stocks sensitive to the global economy, the likely slowdown in consumption and the supply chain issues are likely to continue to underperform. Richly valued stocks (mainly tech) are still vulnerable, especially those reporting disappointing results or forecasts. Be very selective there.