Let your profits run – but don‘t chase the rally
Key Points
Year-end rally: as we had expected, markets eventually took off for a year-end rally which has unwound the full downward trend of the previous three months. Other than seasonality and positioning, the driving force has been an almost perfectly composed set of economic data. Almost all releases since late October have been about as friendly as the market could have asked for. e.g. 150k payrolls are strong enough for a soft landing but weak enough to keep the Fed at bay regarding further hikes. The 0.2% rise in CPI should give the Fed further comfort in their successful fight against inflation and there is no longer the need to fight a future easing of financial conditions.
How much gas is left in the tank? Based on history, the recent recovery is by no means unusual. Albeit a bit faster than history suggests, it is quite common for the market to see a meaningful recovery after a 10%+ correction. We still like the technical set-up for the rest of 2023, implying that there is some gas left in the tank. At the same time, it’s worth keeping in mind that a serious amount of short exposure has already been covered and, compared with the picture a month ago, there’s less upside potential left.
Valuation is not on the side of the bulls either. Although we doubt that it will matter in the short term, it is likely to cap returns further down the road. Our economic expectations of slower inflation and slower growth (in the US) should constitute some further headwinds.
Main recommendations
(+) Upgraded EU Tech to Positive. The sector is well positioned to capture the growth potential of B”B application growth while valuations are low.
European Utilities showed some relative strength this earnings season leading to substantial positive earnings revisions. Valuations are low and positioning is light. We see room for further upside, especially if rates continue to fall.
Stay diversified including in some cheap and solid cyclical stocks (Energy, European Financials).
(+)Country-wise, we maintain our Positive stance on the eurozone, UK, Japan and Latin America
Be cautious/selective with expensive market segments, such as Consumer Staples, some large-cap US tech stocks and some Consumer Cyclicals: pricing power is weakening and operating profits are under pressure from rising costs. Some very high P/E ratios are difficult to justify.
The key risks are that the US Federal Reserve or the ECB could raise interest rates more than expected, triggering a sharper economic slowdown or even a recession. Liquidity is likely to fall in the coming months, especially in the US.
Equity outlook
Rising global liquidity and looser financial conditions are key motors for stocks. Another supportive factor may arise from corporate share buybacks which are likely to be the greatest source of demand for stocks in the near term. As there is a lack of new issues coming to market, this net shrinkage of equity supply suggests a moderately supportive backdrop for stocks.
In general, valuations remain relatively cheap versus history for US (excluding megacaps), European, UK, Japanese and emerging market stocks across a number of metrics such as P/E. However higher valuations will require lower long-term interest rates, i.e. falling 10-year bond yields.
Earnings momentum will be key, particularly given the lack of growth in the eurozone and our expectation for a US economic slowdown in 1H24. Up to now, decade-high inflation rates have allowed companies to expand profit margins as they have enjoyed pricing power, while strong consumer demand has also supported top-line growth. As consumers are growing less confident and as headline inflation recedes to more normalised levels, these two indicates weakening earnings ahead. Up to now, these potential drags have not impacted forward earnings estimates. But this could still change, if the economic outlook worsens. US stocks have traditionally gained approximately 13% over the six months following a Fed pause. Since the Fed last raised rates to 5.5% at the end of July, US stocks have not progressed. Until the end of January 2024, global stocks may benefit from greater certainty over the end of the central bank rate hiking cycle, based on the typical pattern following a Fed pause.
The real question for stocks in 2024 is the length and depth of a US recession. In the event of a recession, any bear market typically begins roughly one month after the first Fed rate cut, as the economic downturn becomes evident. We see the Fed starting to cut policy rates in June, suggesting that the crunch time for stocks will likely be 2H24. Note that the more severe a recession, the deeper the drawdown for equities. As we expect only a modest US recession in 2024, we look for a relatively small increase in unemployment. This, in turn, would imply a relatively modest headwind to 2024 corporate earnings, and thus a correspondingly lower risk to stock market momentum over 2H24. All of this suggests that we should not rush to downgrade our Positive stance on global stocks for now.
Japan - Still ignored by (too) many
There was little reason for investors to care about buying Japanese stocks during decades past. Japan had weaker relative fundamentals and was reluctant to carry out corporate reforms during most of the 1990s and 2000s.
This is now changing in a meaningful way. Improving fundamentals and governance reforms (which are even encouraged by the Tokyo Stock Exchange) are increasingly hard to ignore. Policymakers continue to push for more competitive and capital-efficient companies, resulting in strong EPS growth and increasing distributions of excess capital.
And yet, most international equity strategies seem to not care as they remain materially underweight Japanese equities. Of 225 actively-managed strategies in the eVestment database, listing the MSCI EAFE (DM ex-US) as their benchmark, 84% are underweight Japan by an average of 7.5% as the chart indicates.
We take this as an additional positive for our constructive stance on Japanese Equities and reiterate our OVERWEIGHT rating.
Emerging Markets (i)
Something seems to have happened after the Fed extended its “pause” to 4 months of no change. When looking at the price action in emerging market assets (stocks, bonds, FX) it increasingly looks like the market has made its mind up: the Fed is done.
This is good news, as the key catalyst for Emerging Markets is going to be the Fed. Only when the market truly believes that the Fed has finished its hiking cycle, we will most likely witness the strongest possible upside catalyst for EM assets.
Only then will the market care once again about the strong valuation case for Emerging Market assets, the extreme pessimism on EM (big outflows, light allocations, general bearishness), and the fact that EM central banks as a group have begun to clearly pivot towards rate cuts. Keep in mind how fast the market turned in October 2022 on vague hopes of inflation peaking!
The line in the chart is showing the equally-weighted prices of EM equities, EM local currency bonds and a basket of EM currencies vs. the dollar. The shaded area is a combination of breadth indicators for EM equites. As shown, asset prices started to recover and are looking to break a long-term down trend. This is happening as breadth among EM equities is increasing.
Asian Equities view
•Asian equity markets had a strong month in November (except for China A-shares), thanks to a decline in US yields and the greenback from peak levels.
•Sentiment on China remains weak despite newsflow that China authorities will ramp up support to the property developers, including a list of 50 developers eligible for a raft of financing, and the authorities may allow financial institutions to offer unsecured short-term loans to qualified developers for the first time.
•However, the key for any meaningful and sustainable improvement in Chinese developers’ liquidity situation is a property sales recovery, which will require the revival of domestic confidence.
•Next to watch in China: the Central Economic Work conference in mid-December that will set the economic policy direction for 2024. We will be watching to see if some stronger and coordinated fiscal, monetary and housing stimulus will be announced after the meeting.
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