Looking through rollercoaster markets

As the first quarter of 2023 draws to a close, the risks and opportunities in the world economy and financial markets are still finely balanced. Global stock markets have become more volatile, sending investors on a rollercoaster, as central banks have tightened monetary policy including raising interest rates. The direction of interest rates continues to be the subject of considerable debate, along with the outlook for company earnings, the potential for recession and the impact of China’s reopening.

In balancing these competing forces, our overall view is that global growth (real GDP) will emerge a little below trend for the year, at around 1.5%.¹ This assumes that inflation will decelerate, and central banks pause on rates, with the Federal Reserve leading the way. China’s reopening will have a moderate stimulus effect for the global economy, creating a ‘soft-ish’ landing.

Against this backdrop, stock markets can continue to progress, but are likely to see considerable volatility and there is the potential for some deceleration in company earnings’ growth. As such, we think a defensive strategy is still warranted, with a focus on dividend yield and sound cash flows.

We believe any contagion from the banking turmoil has been contained. Levels of bad loans are far lower than during the Global Financial Crisis (GFC). Many banks have mark-to-market losses on their holdings in treasuries and quality bonds, but this is a less intractable problem and would be largely resolved if bond yields drop. In addition, the cost of interbank lending is still low, showing that banks are still willing to lend to each other, unlike during the GFC.¹

Nevertheless, there remain a number of clear risks. The first is a global recession. Central banks have a poor track record in engineering a soft landing for their respective economies. However, although the global economy remains weak, the growth picture has notably improved since earlier this year and global recession fears have eased. This can be seen in Purchasing Managers’ Indices (PMIs) across the world.

Should the global economy weaken further, there is a risk of earnings downgrades. This would put pressure on stock markets, but it has not materialised to date. Bears would argue that this means there is room for further downgrades, while bulls might say that it shows resilience from the corporate sector. It is clear that for the time being, the market doesn’t believe company earnings downgrades will be severe.

Geopolitics remain fragile. It is clear that the Ukraine crisis has created greater tension between autocracies (i.e. Russia and China) and democracies (i.e the West). Russia and China have moved closer to each other. Russia sees China as a key strategic partner in terms of its competition with the West and a lifeline for trade, while China sees Russia as a useful tool in its challenge to the Western-led world order. OPEC appears to have sided with the autocracies, cutting oil production at a time when energy prices were high. These tensions are unlikely to dissipate.

The US dollar has been declining from its highs, as the interest rate spread between the US and elsewhere narrows. Also, international fund flows are moving away from dollar assets. If risk appetite were to increase, this would also diminish the appeal of the dollar. In general, we believe momentum is moving away from the dollar, and this should be helpful for growth elsewhere.

China’s reopening may also act as a catalyst for global markets. Global manufacturing PMIs are improving, led by the stimulus from China and this should support global growth. At the same time, the jobs market in the US continues to be relatively robust. These two economic behemoths are helping drive growth and could help create the soft economic landing we expect.

On earnings, we have seen corporates showing stronger-than-expected pricing power. Even with flat economic growth, companies have been able to raise their prices, often ahead of inflation. It’s been a cost-of-living crisis for individuals, but a cost-of-living boom for corporates. Profit margins remain elevated across, Europe, the UK and the US – and are above pre-pandemic levels.

The final element that stock markets have in their favour is their valuation. The price-to-earnings ratio for the MSCI All World Index has moved from 20 times to 15 times over the past two years¹. This indicates that share prices are now cheaper relative to company earnings than two years ago.

We continue to focus on a number of key themes. The first is to seek out companies with a compelling dividend yield. This leads us to defensive areas, backed by solid cash flows and to the UK and Europe over growth-led US markets.

We see a more general renaissance in European stocks. With an energy crunch averted, we are starting to see consumer and business confidence returning. Earnings for European corporates have been stronger than their US counterparts.

Asia ex-Japan should be a beneficiary of a weaker dollar and China’s reopening. The Chinese market still has relatively low valuations and the Chinese economy continues to beat economists’ expectations. This should galvanise the wider region.

It may also be a moment to look at longer-dated government bonds, with yields high relative to recent history. If the interest rate cycle turns, there could be value in having some interest rate sensitivity in a multi-asset portfolio.

The world economy and financial markets remain finely balanced, and a recession remains possible in a number of key developed economies in the second half of the year. However, the picture has undoubtedly improved since the start of the year, which may create less vulnerability for these rollercoaster markets.

Source

¹ Refinitiv / Evelyn Partners