If we look back on the year so far, the market has faced a number of obstacles from regional bank failures, escalating tensions between China and the U.S., continuation of the war in Ukraine, to a surge in AI-related technology. While at the same time, central banks continue to raise interest rates trying to fight stubborn inflation.
Despite all these complexities, the S&P 500 and Nasdaq 100 have performed well – up 17% and 40% year-to-date, respectively. However, these gains have been lopsided, with a handful of mega-cap tech companies accounting for the majority of the outperformance and distorting valuations.
As we approach the backend of the year, let’s have a look at our mid-year scorecard; reflecting back on our offshore outlook that we gave at the beginning of the year.
Global GDP Growth Proves More Resilient
We started off the year, expecting global GDP growth to slow and major developed economies forecasted to dip into recession in the first half of 2023. And while GDP growth has slowed, economic growth has proved to be more resilient; pushing out the probability of a recession, if any. GDP has been stronger than anticipated, with positive revisions to near-term estimates on the back of robust consumer spending and a strong labour market. The resilient economy coupled with better-than-expected corporate earnings have investors looking past near-term volatility and towards the next rate-cutting cycle.
Interest Rates Higher for Longer
Entering 2023, we were anticipating that the Fed would only hike rates twice in 2023, and thereafter pause at 5% before potentially cutting rates down to 4.5% by the end of the year. As the year progressed, stronger GDP and stubborn inflation caused the Fed take a more hawkish stance; lifting rates 4 times up until the last meeting in July and increasing their 2023 exit rate by 50bps to 5.5%. Consequently, rate markets have adjusted their forecast, now only expecting the first cut in 2024.
The market and the Fed have been at odds in their forecasts since the start of the rate cycle, but given resilient GDP and stubborn inflation, the question remains whether the Fed will rate hikes by an additional 25bps this year or keep rates unchanged.
Inflation Falls But May Prove Sticky
Inflation has progressed as expected. However, while we may have turned a corner on inflation, we expect inflation to bounce around the 3-4% range. As the sharp rise in commodity prices driven by the war in Ukraine works its way out the system, moving inflation down from 4% to 2% becomes more difficult in a more normalized environment.
The jury is still out whether the Fed needs to keep its foot on interest rate hikes or step back and reassess its inflation target.
Equity Markets Follow Historical Precedent
As stated in our 2023 outlook, evidence shows us that equity markets typically rebound after a big drawdown in the prior year. Historically, after a 25% or more pullback, the S&P 500 returns an average of 20% over the next 12 months.
Following Large Market Drawdowns, Longer-Term Investors Are Rewarded Over Next 3-5 yrs for Leaning Into Dislocations
Year-to-date (YTD) this is exactly what has occurred. Equity markets have performed very well, with impressive performance in growth and big tech names, and remain on course for good returns in 2023.
Where to from here?
The most important thing from our perspective is to work out what we can expect from global equity markets over the next 6-12 months. When we step back and consider this question, we try to frame it in terms of what the big technical drivers are and then hone in on specific stocks that can benefit within this framework. When considering the current structure of the U.S. market, we look at valuation and whether stocks are under- or overvalued, the direction of earnings, the potential for rate cuts to impact markets, and where the institutional investment fund managers are positioned to determine any future investment flows.
Valuation – Not As Stretched As At First Glance
On the surface, S&P 500 valuations may look stretched at almost 20x forward earnings. However, scratching below the surface reveals the fact that the strong year-to-date rally in technology stocks has driven the recent run up in valuations. Stripping out the mega-cap tech names uncovers a market that is trading at a valuation significantly more attractive than first meets the eye. At 15x forward earnings, the S&P 500 ex Tech remains attractively priced.
Earnings Have Bottomed
Reasonable valuation is not a reason to solely to own a stock. You need to have a catalyst that has the potential to drive valuations higher. Typically, valuations fall when earnings growth deteriorates, and analysts are continuously cutting estimates. This is a scenario we experienced for the most part of this year as slowing revenue growth and rising costs impacted corporate earnings. However, we are starting to see the first signs that management teams are beginning to get on top of costs. Operating margins are beginning to stabilize and, in some cases, actually increase as businesses are right sized. It is evident that earnings growth is bottoming and in fact beginning to turn up. It is this dynamic that gives investors confidence that we have seen the bottom in the earnings cycle and leads to multiple expansion going forward.
Rate Cuts On The Horizon
Since the Fed began tightening rates, investors have been placing bets on when they will be done and begin to reduce them again. This is important as interest rate cuts result in a stimulus to the economy which in turn kick-starts revenue growth. Historical data tells us that equity markets in general generate solid returns once the Fed pivots and the next move is a reduction in rates.
While the Fed pivot to date has been pushed back, we are close to the end with the first rate cut forecast in March 2024. Market participants are now in Fed watch-mode trying to front run any pivot type announcement.
Dry Powder – Cash Waiting On The Sidelines
Despite the increase in equities year-to-date, global fund managers remain underweight equity allocations across their portfolios. Additionally, fund managers are sitting on relatively high levels of cash. This means that global fund managers haven’t really fully participated in this year’s stock market rally, so are likely underperforming their benchmarks. They are more likely than not waiting for confirmation from the Fed that they are done with rate hikes before re-entering equity positions. As cash comes back into the market it will create momentum as buyers outnumber sellers.
Given these factors, we are confident that equity markets are well placed to continue to offer positive returns over the next 12 months. We do believe that leadership will change hands, so it is important to pay attention and be positioned in the areas that are likely to benefit from the various dynamics in the markets.
What we Like!
AI has fast become the hype word, with many stocks that are perceived to be beneficiaries gaining significantly on the back of yet to be seen earnings growth. There is no doubt AI is catapulting us into the next technological revolution – the jury is still out who will be the winners and losers. At NVest Securities we are also aware of the price we pay for an investment is ultimately the primary decider of return. The AI ecosystem is large and there are lots of AI opportunities at reasonable valuations to take average of, rather than jump into the likes of Nvidia which is already pricing in significant upside. Ultimately, we do believe that higher multiples may be justified given the revenue growth step change that will be driven by the emergence of AI.
Outside of AI beneficiaries, an environment where the Fed has stopped tightening rates is conducive to the outperformance of value stocks. We are focusing on those names where margins and earnings growth have stabilized and are trading at valuation discounts. Global financials should benefit from high net interest margins and stable-to-declining credit losses. Additionally, the structural shift in energy markets and renewables also creates an interesting thematic that promises attractive longer-term returns.
In summary, while the markets have performed well year-to-date, we remain confident that there are enough catalysts to drive attractive returns over the next 12 months. More than ever, this is going to be a stock pickers market, so being in the right areas at the right time is going to be paramount.