#Articles — 19.12.2022

Equities Focus December

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

Upgrade to Positive


Equities at a glance: Upgrade to Positive

Key Points

1.Upgrade to Buy on stocks: look through a temporary dip to recovery beyond (12 month horizon). Key drivers include falling US inflation, lower long-term interest rates, improving macro liquidity, and easing energy prices. Build stock exposure gradually, use short-term market consolidations to add, favour value and World ex- US over US.

2.From Neutral to Positive on cyclical sectors – Materials, Banks. Mining should benefit from rebounding Chinese activity and low base metals inventories. European banks should benefit from surprisingly resilient consumption, a rising ECB deposit rate, rising Net Interest Margins and solid capital ratios. Both Mining and Banks remain cheap versus long-term average P/E and price/book value ratios, offer generous dividends.

3.Short-term market consolidation likely: after the sharp equities recovery in Oct/Nov, some sort of consolidation is likely in December. Further gains will depend on how fast inflation falls, how soon key central banks ‘pivot’ and how much the global economy and earnings stay resilient. 


Key recommendations


Prefer ex-US regions to the US: since mid-2008, US stocks have beaten the stocks in the Rest of the World, by a wide margin. This was driven by outperformance of technology-related growth stocks and the US dollar. Since October, this trend has started to reverse, with the value factor beating growth. World ex-US valuations trade today at a record discount to US stocks, suggesting future long-term outperformance.

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.


Key Risks: US inflation not declined as fast as we anticipate. 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.


1. Our 5 key Equity indicators have turned up

5 reasons to upgrade our stock view

1.(Lower) inflation rates, peaking central bank rates: we expect US inflation to fall rapidly in the coming months, on the back of moderate demand, easing supply chain pressures, a weaker housing market and lower fuel prices. We also see easing labour market pressures, as the corporate focus turns to reducing staff rather than adding.

2.Falling energy price pressures: the single biggest element of European inflation is painfully high natural gas, electricity, and diesel prices. These prices have all eased substantially since the August peak, while LNG imports from the US continue to increase. Adapting industrial and consumer energy demand should also help lower price pressures ahead – the cure for high prices is high prices.

3.(Lower) Real bond yields: 10-year bond yields have fallen 0.6%-1.0% since the October peak, pushing down real yields. These lower real rates support equity & corporate credit valuations - reversing the situation since January, when rising long-term rates lowered fair market stock valuations.

4.(Looser) Financial conditions (credit spreads, volatility, interest rate spreads): lower US and European investment-grade credit spreads, lower stock market volatility, improved global liquidity all contribute to looser financial conditions in the US and Europe compared with the mid-October peak in financial conditions.

5.(Weaker) US dollar index: since the September peak, the Bloomberg US dollar index has fallen over 6%, breaking its prevailing uptrend in place since May 2021. We expect an even weaker US dollar over the next 12 months.


2. Equities Outlook

Tilt towards value factor, sectors, world ex-us

Within our positive stance on global stocks, there are a number of clear trends and preferences that we would highlight for investors looking to gradually deploy cash back into stocks after a tough 2022 to date.

Stay the course with Energy: we believe that energy prices have an asymmetrical outlook – a much higher probability that they 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 index.

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 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. 


3. Focus on Value

The pendulum swings back finally to value

Growth the recent winner: from 2016 to 2021, growth stocks have 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 holds the overall performance lead, 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 pharmaceutical companies 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.


4. Focus on unloved European stocks

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. In the 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 imply higher long-term returns from here.

European earnings have been resilient

While economic pessimism abounds in Europe thanks to the energy crisis and its impact on investment and consumption, earnings forecasts have (up to now) only seen modest downgrades (see next page). In contrast, stock prices have adjusted much more sharply this year, with European equities suffering record investor outflows. While it is reasonable to expect these earnings forecasts to ease further in the months ahead, there is still plenty of scope for stock prices to more higher to realign with earnings. 


5. Q3 earnings & forecasts

A mixed bag in the us; big tech disappoints

In the US, Q3 revenues grew a bit more than +11% compared with last year (slightly better than expected). Earnings were also slightly above (revised down) expectations, with growth of +3% ‘only’, compared with Q3 2021. Quite disappointing. New forecasts in the ‘Mega Tech’ sphere shocked the markets in several cases. Margins are under pressure (higher wages & costs, strong USD, etc). Downward revisions were abundant, especially in the tech sector. Companies have started laying off employees.

Valuations are getting rich again in the US: after the Oct/Nov rally, the forward P/E is now 18.1. Tech, Consumer Discretionary and Staples Sectors trade at average P/E levels above 20. Industrials are also approaching this threshold. 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. 

Relatively better Earnings in Europe

European companies have displayed resilience in most sectors. Revenues have beaten expectations by slightly more than 4% on average and earnings by 5%. 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 +18.6% in Europe but almost zero growth is on the cards for 2023. As mentioned last month, inflation is key, and its 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 of 12.1. Some sectors that perform well during inflation times are very cheap: Energy, Financials (Banks are upgraded to Positive this month), Health Care, but also Materials (also upgraded to Positive this month). 


6. Asian Equities view –Positive on China

•Chinese equities rebounded strongly in the month of November on hopes of a full reopening as well as support for its ailing property sector. The Chinese government unveiled 20 measures to guide easing of restrictions while also introducing sweeping rescue policies to avert a full-blown property crisis in November. With a more encouraging macro outlook, investors are flocking back into Chinese equities with expectations that the reopening of China will come sooner rather than later.

•We are turning more positive on the broad Chinese market, as we believe most negatives have been priced in and further significant downside may be limited. Shifts in policy stance (COVID & real estate) are very encouraging, while progress in vaccination will be crucial for the latest rally to translate into a full recovery. Despite the recent rally, valuations remain very attractive. There could still be near-term volatility, but any of such volatility can be viewed as an opportunity, particularly for policy beneficiaries.

•We remain overweight Singapore and Indonesia equities, which are significantly outperforming year-to-date. Singapore continues to benefit from first mover advantage of reopening, while continuing to remain attractive with its high dividend yields. Indonesia has been helped by the commodity cycle, rising local consumption and reopening in South East Asia as well. 

7. Good Long-Term Outlook for Mining


Economic pessimism holds back mining, for now

Since the start of 2020, the MSCI World Mining sector has managed to outperform the benchmark MSCI World index substantially in spite of current global recession fears, gaining 58% cumulatively (including dividends) versus an 18% gain for the MSCI World. In 2022 year-to-date, these recession worries have not stopped global miners returning +10% to date in US dollar terms, while the MSCI World has dropped 16%. If economic pessimism proves overdone, and the Chinese economy gathers speed in 2023 on the back of policy stimulation and relaxation of their zero COVID policy, mining companies could see a better 2023 earnings outlook.

Earnings, cash flow growth not reflected in price

Since the beginning of 2016, aggregate forecast earnings for global mining companies have grown by 457% (in USD) to December 2022, including the sharp fall in earnings estimates since May on the back of intensifying recession concerns.

Mining company share prices have lagged dramatically over this period. Share prices have only gained 188%, implying a huge P/E de-rating since 2016. Today, the STOXX Europe Basic Resources sector trades at very cheap 8.4x PE, 3.5x EV/EBITDA and 6.7% dividend yield valuations, on the back of cash flows that are projected to continue to grow further in 2023.


8. Positive on Materials and Banking


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. 

Next to mining, other opportunities EXIST in materials

Commodity stocks are extremely cheap and yet very profitable. In 2022, the market has 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 as 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 very reasonable at present. 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. Furthermore, 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

The economic slowdown should be milder than expected; materials and banks likely to outperform

Our favourite sectors have been performing well this year. The latest corporate earnings season supported our views. This month, considering significant improvements in China as well as the resilience of the global economy, we upgrade the Materials sector (quite correlated with China) and the Banking sector (cheap and never been so solid) to Positive. 

¡China has taken significant measures to stabilize the economy, in particular the troubled real estate sector. The COVID crisis has also been hurting the population, and authorities now seem willing to become less strict.

¡At the same time, Western economies have been quite resilient (despite some weak confidence indicators). Energy and other costs are more under control. The Materials sector was quite affected by this adverse environment that now seems to be improving, at least in the short term. Besides, this sector is still relatively cheap. The environment now also looks much better for Banks (rising net interest margins, resilient economy). Therefore, this month, we upgrade Materials and Banks to Positive. 

Inflation, though receding, is still high and we recommend to keep good positions in sectors performing well in this type of environment (Energy, Basic resources, Financials, Health care).  

¡Regarding European REITs, the worst should be behind us (bond yields have receded); they trade at huge discounts to NAVs and they are now trying to recover.

¡We still advise keeping a good chunk of any equity portfolio invested in companies with pricing power. Q3 results and forecasts proved once again that this is one of the best segments to be invested in this year.

¡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 Growth/ Tech) are still vulnerable, especially those displaying disappointing results or forecasts. Be very selective there.