Last year was tough for equities. The bad news is that the outlook for 2023 looks equally bleak. This puts investors in rare territory as records show that two consecutive negative years for equities have only happened four times in the past 100 years.
There are similarities to historical equity downturns. In 1974, the market was stifled by an overbearing inflationary picture. Then in the early 2000s, there was a tech boom and bust: a situation now playing out in slow motion in that it is taking place over a longer period. An indication of the fall of tech is the demise of the once-favoured investor trend of the FAANG [Facebook, Apple, Amazon, Netflix and Google] giants.
Beyond the historical comparisons, there are other reasons – to misquote singer Ian Dury – not to be cheerful. The most fundamental is that relative to their underlying earnings, shares remain expensive on a historical basis. Even the biggest blockhead could work out that this is far from ideal.
Putting the picture into perspective, Carrie King, global deputy chief investment officer at Blackrock’s fundamental equities division, says: “In equities, we believe recession isn’t fully reflected in corporate earnings expectations or valuations.”
Here the investment environment is reaping what the wider financial world sowed. That is to say, today’s valuations are a result of central banks in the US and Europe injecting an abundance of liquidity into the market through quantitative easing. But now that these programmes are being reversed, the repercussions are feeding, albeit slowly, through the financial system.
One of the ways this has become evident for investors is the failure of the 60/40 portfolio, which plunged 17% last year. This poses the simple question: why go for equities when you are going to get hammered?
We shall not be moved
Such a picture does not augur well for institutional investors. How then should pension schemes, insurers and charities address this precarious situation? While corporate defined benefit (DB) schemes have reduced their equity exposure, stocks continue to be a cornerstone of open DB schemes and defined contribution portfolios. Investors, who still require income, open DB schemes, DC among others, have taken different positions in response to the equity malaise.
The first is to stick it out. This is the position taken by George Graham, fund director at the South Yorkshire Pensions Authority. “We have a long-term investment horizon, so ‘sticking it out’ is part of the approach. Although that doesn’t mean we ignore underperformance by fund managers or significant secular trends, which might cause us to rebalance between or out of markets,” he says.
Nevertheless, there also exists a degree of investment pragmatism in South Yorkshire’s approach, which involves shifting to other asset classes. But for Graham it is important for his fund to hold assets that have capital and dividend growth. “We need to maintain exposure to growth assets, and listed equities are a key part of this,” he says.
The ‘stick it out’ approach is also shared by Richard Tomlinson, chief investment officer at Local Pensions Partnership Investments. “It will definitely be a keep calm and carry on approach for us,” he says. “We will not be dumping equities. We look at the long-term horizon. “Within equities,” Tomlinson adds, “we have a more effective, quality-type of approach, which means we tend to invest in stuff with a long-horizon, a Buffet-style portfolio: earnings effectively for the long run. We don’t try and make regular calls on equities.” This is a typical truism for many open DB schemes: the long term is all.
Such an approach is shared by Matthew Cox, investment director at the Esmée Fairbairn Foundation, a charity that aims to improve peoples’ quality of life. “We have a long-term time horizon and, as such, keep a high exposure to equity markets. Any adjustments we make are likely to be at the margins and related to rebalancing,” he says.
An alternative view
That said, the ‘stick it out’ approach is not the only stance investors have opted for. Inevitably, given the outlook, there is a view to look at other portfolio options beyond the asset class. Even someone committed to equities like Graham is looking at his portfolio in more detail.
“We will, as part of our strategy review, be looking at the scale of our UK and emerging market exposures, partly given the scale of exposure relative to GDP weighting and in the context of long-term performance in emerging markets,” he says. Will Ballard, head of the equity investment team at Border to Coast, has identified an asset class he considers a solid alternative to equities. “An area we believe offers attractive value in 2023 is the listed alternatives sector,” he says. “Average discounts to net asset value across infrastructure, real estate and private equity investment trusts are close to the post-global financial crisis low.”
Digging deeper on this, Ballard adds: “The sector’s sensitivity to interest rates means that this is likely to shift from being a headwind to a tailwind as expectations for central bank policy begin to moderate. “The sector offers investors an attractive entry point into long-term secular growth themes, such as renewable energy, and its highly predictable cashflows should provide resilience in the face of any weakness in the global economic environment or more persistent inflationary pressures.”
Secondly, he sees attractions in technology – or at least technology companies that stand apart. “In technology, companies that differentiate and distance themselves through unique intellectual property or business models, and which have assembled impressive innovation and go-to-market engines, are likely to have greater opportunity to achieve important scale in their core businesses, which could enable them to dominate the landscape,” Porter says.
Tomlinson admits that as a long-term investor, technology is something he is keeping an eye on. “As I say, we look at the long-term horizon, and here, there is a big question about tech and where tech goes over the next 10 years.”
Great transformations
But it is not all about healthcare and technology. “Industrials engaged in the transformation of materials, substances or components into new products are driving innovation around areas such as energy transition, infrastructure, and the move to electric vehicles,” Porter says.
Finally, he notes the energy sector also appears attractive as the severe energy supply crisis takes hold of the world. “Many energy companies are employing new business strategies as they focus on capital discipline, returns and returning cash to shareholders,” Porter adds. “Energy has also proven to be an under-owned sector despite showing robust performance over the past 12 to 18 months.”
A third option for investors is to seek equities that will not be struggling, as they will not all be equally cursed. Ballard gives some indications of his thinking, highlighting that emerging market equities offer a reversal on recent times – having struggled during the past 12 months and being one of the worst performing equity markets.
“China’s growth slowdown exacerbated by structural issues in their property market and their approach to handling Covid has been a near insurmountable headwind,” he says. “This has resulted in low expectations for earnings growth combined with cheap equity market valuations.”
Great recovery
Putting a more positive spin on the situation, some asset managers have sprinkled a little gold dust on the stock market outlook. JP Morgan has argued that stocks will end 2023 higher than they started, a point echoed by Goldman Sachs, which believes near-term share price falls will recover by the year end.
Indeed, market moves have presented a different picture from the pessimistic view that seemed to prevail. January saw what appeared to be a recovery, with the US equity market rising by close to 5%, European equities up 9% and even emerging markets climbing within touching distance of 6%, all offering a clear encouraging jump.
Will Ballard puts these, and other events, into an investor’s perspective. “The recent indications that the high levels of inflation experienced globally have started to soften, gives us cause for optimism,” he says.
Such a reprieve, Ballard says, would give central bankers greater flexibility on monetary policy, moderating the pace of interest rate increases and perhaps with time, bringing them to an end. “This is supported by the latest IMF global growth forecasts for the coming year, which show an improvement in their expectations for growth across almost all countries other than the UK,” he says.
An upbeat view
Looking at other factors that could be playing a positive role, Ballard notes the slow pace of growth expected for the global
economy has, to some extent, already been factored into the markets’ expectations for corporate profitability. And with consensus expectations for earnings growth for global equities this year having already dropped to 3%, a significant slowdown from 2022, while global equity valuations themselves are not excessive, being close to their 10-year average, all provide a more positive picture.
All these together contribute to a more upbeat equity outlook, Ballard says. “This combination of reasonable valuations, reasonable expectations and some initial signs that inflation, global growth and monetary policy may not all be such persistent headwinds gives us cause for optimism when it comes to global equities.” Dan Mikulskis, a partner at consultancy Lane Clark & Peacock, is also upbeat. “Many 2023 macro outlook forecasts were quite pessimistic, seemingly everyone agreed a recession was coming. But markets have enjoyed a pretty spectacular start to the year up almost 10%, and data such as strong US jobs numbers and warmer European weather are throwing doubt on the recession story,” he says.
There are two key issues here though which create difficulties for investors. “One is the question of what is already priced. The market falls during 2022 priced in quite a lot of bad future news, so the news only needs to be a little better than the low expectations to generate a relief rally,” Mikulskis says.
Market loops
The second is the potentially confusing nature of the feedback loops. “Sometimes markets fall on news that suggests a strong economy – in anticipation of more interest rate rises – other times they rise on good news in sympathy with future economic strength,” Mikulskis says.
This means investors should be extremely cautious trying to time entry into and exit out of equity markets. “Generally stock investors are rewarded well over the long term and it is a notoriously tricky business trying to finesse the timing any more than that,” Mikulskis adds.
Thankfully, as a broad rule, many investors – at least asset owners – admit they are sticking to it. There are other factors that could still have an impact on the equities picture in 2023 and beyond. Graham sums this up. “Much will depend on Harold Macmillan’s old friend, ‘events, dear boy, events’. Progress of the war in Ukraine will clearly impact the profitability of traditional energy companies while also attaching a premium to those companies that are key to delivering alternative forms of energy, potentially positively or negatively,” he says.
Tomlinson concurs on the impact of a big event, which, from an equities’ perspective, could be a game changer. “If something ugly happens this year, say a serious escalation of conflict in Europe, that is likely to lead to equities having a really tough time. At that point, we may need to add to our exposures.”
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