David Philpotts – Head of Strategy, QEP
After a bruising 2022 for investors, we outline below the key themes for 2023 and beyond. We are deliberately taking a balanced perspective across a number of issues rather than falling into the trap of making specific short-term forecasts. The past few years should have taught us all that it is far more important to take the long view. As part of this, assessing the point of departure provides the best clues as to what may lie ahead, primarily by focusing on current valuations.
1. The risks are still skewed to the downside for equities, albeit less so than a year ago
Investors are staring down the barrel of a profits recession which does not appear to be priced in:
– Valuations are still not compelling even after last year’s decline
– Earnings are still adjusting downwards but too slowly
– Inflation has peaked but may prove sticky with investors underestimating the US Federal Reserve’s (Fed) resolve to not repeat the mistakes of the 1970s
At the very least, this is likely to lead to further swings in sentiment as the market digests the flow of noisy economic data and attempts to second guess the Fed. That said, it would still be unwise to rule out a rosier outlook. The main upside risk is that the US sidesteps recession, or it is shallower than expected, meaning that the Fed is able to pause, and potentially ease, earlier.
2. Value has much further to run despite a strong rebound since late 2020
There is still a significant and widespread valuation buffer. Even a normalisation back to value’s long-term discount to the broader market implies that the cheapest third of stocks will outperform by almost 12% over the next three years.
We are also not being forced to make a trade-off between value and quality at the moment, meaning that we can take a broader exposure, including affordable quality stocks. These also tend to be more defensive and generate a smoother journey. However, many deep value stocks have already moved higher and avoiding the traps will still be critical.
3. The honeymoon for the FANMAG stocks is ending
On the other side of this trade, the jury is still out on whether yesterday’s growth stocks now offer good value. At the time of writing the US technology sector is trading on a forward price-to-earnings multiple (a key valuation metric) of just over 20x, down from around 30x a year ago. But this still represents a 20% premium to the broader US market and a 41% premium to MSCI All-Country World Index.
In terms of the FANMAGs (Facebook, Apple, Netflix, Meta, Amazon, Google), our view is that as a cohort they are more fairly priced but are far from bargains. Without their support, the US technology sector may no longer be the leading driver of stock market returns, even if bond yields decline again as we pass through the economic downturn. Disruption is the norm but investors had it too easy identifying the winners for a short period of time.
4. The reign of the “king dollar” has also passed
One observation, that is both a catalyst to rotation and a reflection of a broader shift in sentiment, is that the dominance of the US dollar appears to have peaked last September. In terms of who will be the beneficiaries should this situation persist, once again we return to valuations. Based on the deviation of real exchange rates from their historical average, the US dollar is still the most expensive currency out of the major markets (17% above its average) whilst the yen remains very cheap (25% below average). However, we would be cautious about expecting a straight line for dollar weakness going ahead.
5. The stars are aligning for emerging market outperformance
As with developed markets, it doesn’t make sense to think about emerging markets as a homogenous asset class but some general comments supporting the emerging market trade are:
– Emerging markets are further ahead in the policy cycle
– China reopening
– A weakening USD provides a lifeline for emerging markets
– Valuations are relatively cheap
Emerging markets have recently bounced strongly in response, but investors should continue to look for opportunities to add exposure. However, sustained emerging market outperformance would require an earnings super cycle which seems unlikely at present.
6. US outperformance over the past decade is unlikely to be repeated in the next
Based on valuations alone, the case for a continuation of US dominance does not seem compelling. The US market is currently trading on a forward price-to-earnings of 18.3x, a 48% premium to the rest of the developed world and a 59% premium to emerging markets.
One way to put some numbers on this is to assume that regional market valuations adjust back to their long-run average over the course of the next three years while also taking into account the forecast difference in earnings growth. Such a framework suggests that the cumulative return differential between the developed world ex US and the US is just over 19% between now and 2026, similar to the disparity between emerging markets and the US.
Such a top-down perspective is heavily distorted by index composition, primarily because the US market is concentrated in a handful of more expensive stocks, with much better prospects further down the size spectrum. However, the balance of probabilities does suggest that the hegemony of the US market has peaked for now as valuations are more attractive in other regions and the superior quality of US stocks is no longer as compelling.
7. Sector performance will continue to be important but calling it will be hard
In contrast to the dominance of technology between 2017–2020, which was really driven by a handful of mega-cap stocks, sector dispersion has recently been high by historical standards. It has in fact only been higher in a handful of months in the past four decades. This has offered greater opportunities for active managers to outperform, but calling the right sectors has been tricky.
While recognising the potential for continued high dispersion in sector performance, our preferred strategy has always been to adopt a bottom-up approach and let such concentrations build up from the stock level. It is easy to find good opportunities in most areas of the market at present, which negates the need to take on unnecessary sector risk.
8. Sustainable investing has been challenged of late which reinforces the need for a forward-looking approach
Sustainability focused investing faced headwinds in both 2021 and 2022 due to the strength of energy stocks and weapon producers alongside a broader preference for defensives, namely tobacco. This reinforces the need for an evolving approach that increasingly focuses on sustainability ‘leaders’ and ‘enablers’ rather than simply avoiding the worst in class. ESG strategies exposed to value that also exploit the full opportunity set are also well placed to perform, particularly those that fully exploit active engagement.
9. Keep an eye on emerging sustainable trends – human capital and biodiversity
Investors are increasingly looking more broadly and are increasingly focusing on social and broader environmental factors such as human capital and biodiversity as a driver of company returns. The visibility of nature-related risks, of which climate change is a component, is improving. Policy momentum is building and investors and regulators are increasingly attuned to corporate environmental performance beyond carbon reduction plans.
Moreover, progress on policy and reporting frameworks for climate change will serve as a blueprint for nature-related risks, enabling a much swifter response from regulators and investors. Biodiversity is already an element of our approach to assessing the environmental risks companies face and will also be a major research focus for the early part of 2023 across the three pillars of land, air and water.
10. The big picture is still very uncertain and investors will need to be far more nimble than in the past
Globalisation has provided a tailwind to investment returns for decades but most of the trends that have existed since the fall of the Berlin wall are unlikely to be repeated. The prospect of more unpredictable growth, higher rates and more volatility is a natural consequence of a less certain future.
Alongside the rise of thematic investments, which straddle the traditional classifications of regions, sectors and styles, one consequence is that we believe stock selection will become far more dominant over simple market risk in the years to come. Investors will also need to be more agile in how they respond to evolving market opportunities, potentially requiring more focused approaches (e.g. more building blocks via region-specific mandates). A flexible but scalable bottom-up approach is probably best suited to respond to the challenges such a world poses.
Final thoughts
Our key take away is that history will only provide some of the answers and predicting the future is fraught with difficulty. Instead, it is better to take the opportunities that are pushed our way and spend more time thinking about what is priced in today.
Finally, risk management should be far less concerned with volatility and correlations and focus instead on what could go wrong across a range of scenarios. These themes need to be identified first before they can be effectively managed.
A longer version of this article is available here
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