UPRO - July 2023 Equity Market Outlook: Positive Sentiment Emerges As Inflation Slows

2023-07-26 22:39:00 ET

Summary

• Q2 2023 was a more favorable environment for Emerging Markets, Europe, Australia and Real Assets managers.
• There was no single style factor that dominated returns across markets, with country and sector positioning being more relevant.
• Managers are optimistic about the decline in inflation across the globe, but still expect a mild recession.

As inflation continues to subside, is investor sentiment turning more positive?

Investors have been encouraged by the ongoing deceleration in inflation rates around the globe, as well as by expectations that policy rates are near peak levels. In addition, the agreement on raising the U.S. debt ceiling , retreating concerns related to systemic risks in the wake of the collapse of Silicon Valley Bank ( SIVBQ ) and Credit Suisse, and continued excitement around artificial intelligence ((AI)) are adding to the positive momentum.

However, with a mild recession still expected, managers have a preference for companies with resilient balance sheets and strong business models that can weather the current challenging environment, where cost pressures are impacting margins and investments. Managers also remain cautious on China, due to slowing growth and weak consumer confidence.

On balance, the second quarter of 2023 proved to be a more favorable environment for active managers in Emerging Markets, Europe, Australia, and Real Assets equities, while being more challenging for U.S. Large Cap, U.S. Small Cap, Long/Short, Global, Global ex-U.S., Japan, UK, and Canada managers.

Contrary to previous quarters, there was no single style factor that dominated returns across markets, with country and sector positioning being more relevant. However, the growth and quality factors continued to be rewarded in the U.S., while the value factor outperformed in Emerging Markets, Japan, and Europe.

Information technology was again the best-performing sector across most regions, while energy, materials, real estate, and consumer staples generally underperformed. Financials typically also fared well, with the exception being in the U.S.

Drawing on our unique relationship with underlying managers, we’ve compiled the latest insights from specialists across the manager universe into an easy-to-read report. Listed below are the chief tactical observations from key equity and geographic regions around the globe during the second quarter of 2023.

Australian equities

Same, same

• For the third consecutive quarter, managers largely kept portfolios unchanged.
• Since the second half of 2022, managers have increasingly focused on more higher-quality companies with stronger balance sheets that can maintain margins and revenues in a challenging economic environment.

Less enthusiasm on China demand

• Managers were expecting that the reopening of China post-COVID would increase demand for Australian exports. Outside education, this has not occurred. Managers are now less optimistic on demand from China.
• Few managers are overweight iron ore miners, believing that steel production is unlikely to accelerate. Battery minerals are preferred.
• Demographic shifts in China make productivity and GDP (gross domestic product) growth more challenging in the future. Declining birth rates mean China’s population could halve by 2090.

Canadian equities

High-quality opportunities in energy

• Investors are more optimistic about future opportunities within the energy sector, as many companies have transformed their business models to become more focused on cash flow generation versus production and revenue growth. As such, they have better balance sheets and the ability to withstand commodity price fluctuations.
• Canadian natural gas producers are well positioned within the industry, with a very favorable supply/demand situation. Increasing Asian demand is expected to benefit Canadian natural gas producers. With better logistics for Canadian producers versus their U.S. counterparts, they have a cost advantage to meet demand outside of North America.

Favorable environment for strategic acquisitions

• Despite rising interest rates and a higher cost of borrowing, managers are optimistic about the M&A (mergers and acquisitions) environment for high-quality strategic corporate buyers. The high borrowing costs are reducing competition for deals from private equity, providing more opportunities for conservatively managed corporate buyers with strong balance sheets that have more flexible financing options.

Managers are selective within transports

• While not attractively valued based on current P/E (price-to-earnings) multiples, managers view the rail companies as compelling long-term compounders with great earnings visibility. Rail volumes continue to remain strong, supporting pricing power and durable earnings.
• Managers are cautious on trucking companies, which are challenged by higher input costs and less stable demand.

Emerging markets equities

Is China oversold?

• Despite negative sentiment and weaker consumer/macroeconomic confidence, managers are not capitulating on exposures.
• Valuations are increasingly attractive, which is supportive as managers look to add to oversold opportunities.
• Expectations are that targeted government stimulus will continue and earnings will improve.
• Current high level of short positions on Hong Kong stocks are short-term and can quickly unwind on positive news.

Lower inflation expectations see Latin America buoy up on ideas

• Managers have continued to add to their exposure in Latin America, particularly in Brazil, as expectations of policy easing remain on the horizon due to quicker actions taken to tame inflation.
• Nearshoring remains an active theme among investors as they look to take advantage of opportunities arising as a result.

EM looking increasingly attractive

• Growth differentials relative to developed markets are reaching attractive levels, having narrowed over the last few years.
• The U.S. dollar ((USD)) is expected to continue weakening , which is also supportive for the asset class.

Europe and UK equities

The UK at the crossroads

• Having struggled to forecast the path of inflation, which was stickier than expected in the first half of the year, UK investors are understandably cautious in predicting change as the year goes on.
• However, initial signs of cooling goods inflation, the impact of energy price capping, and signs of food retailers competing on price are giving some managers hope of a positive inflation surprise . This is leading to a greater willingness to increase UK domestic exposure, particularly toward the consumer discretionary sector.

Finally, Europe’s time to shine?

• While Europe has been cheap relative to the U.S. for a considerable time, valuation spread is now at an all-time high.
• Historically, this has been somewhat justified by sector composition and greater EPS (earnings per share) growth out of the U.S. However, the situation is changing, and European 12-month-forward EPS growth is now outstripping the U.S.

Interest rate shock

• Curing a system addicted to cheap borrowing is no easy task and it can have extreme consequences for illiquid or highly leveraged businesses. Unlike 2008, pockets of risk remain in the market despite the average European corporate being well-capitalized.
• The banking crisis in March was a first warning, but worries are now engulfing other companies and sectors. Most notably, the real estate sector - where most companies have strongly benefited from low interest rates - is now struggling to adjust to higher borrowing costs in addition to declining deal volumes and property prices.

Global equities

Embracing AI, but not the euphoria

• AI is a technological breakthrough that will alter the productivity landscape. Growth managers believe that semiconductor companies, along with large-scale cloud providers, are the most direct way to participate in the AI theme.
• Cross application has opened innovation opportunities outside of tech - for instance, material composites and biotech drug design.
• That said, the significant rally in AI-related mega-cap tech names has managers taking profits on peak valuations.

No consensus over China

• Sentiment has turned bearish given China’s slow-paced recovery and underwhelming policy stimulus . Some managers anticipate lower structural growth with an aging population, deglobalization, and weaknesses in the housing market.
• Growth managers, however, view these as near-term concerns that are priced in, particularly in innovation sectors such as internet and technology on the back of easing regulatory pressure.
• Managers also believe that modest monetary policy will suffice to incentivize consumption and allow consumer discretionary stocks to partake in more of the post-COVID recovery trajectory.

Europe remains a valuation story

• Value managers remain attracted to Europe - particularly to financials, where attractive dividends offer a buffer against the rising inflationary environment.

Investors appreciate defensive business models

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