TDIV - May 2023 Equity Market Outlook: More Volatility Anticipated Until Clearer Signs Emerge On Inflation And Rates

2023-05-03 01:30:00 ET

Summary

• Q1 2023 was a more favorable environment for Global ex-U.S., Emerging Markets, Europe, U.S. small cap, UK, Australia, Canada and Global Real Estate managers.
• The quality factor was the standout performer across most regions in Q1, with the growth factor also outperforming.
• Managers anticipate that markets will remain volatile until there is more concrete evidence around the fall in inflation and interest-rate stabilization.

After a first quarter dominated by volatility and reversals, are equity mangers anticipating more ups and downs in the months ahead?

The answer, according to our latest equity market outlook: Yes.

While immediate concerns on potential systemic risks to the economy stemming from March’s banking crisis have abated , banks remain a watchpoint for investors. Managers are also closely scrutinizing inflation, which appears to be moderating.

Overall, they expect market volatility to continue until there is more concrete evidence around the decline in inflation and, subsequently, interest-rate stabilization. Managers also generally still expect earnings to come under pressure in the near term on the back of rising input costs and waning demand.

Despite the volatility in the first three months of the year, the first quarter was another positive one, with all equity markets delivering positive absolute returns. This was particularly the case in U.S. dollars ((USD)), given the greenback’s weakness against most developed market currencies.

USD weakness is expected to continue, particularly as the U.S. Federal Reserve (Fed) approaches the end of its rate-hiking cycle . This weakness should continue to be supportive for non-U.S. assets.

On balance, the first quarter proved to be a more favorable environment for active managers in Global ex-U.S., Emerging Markets, Europe, U.S. small cap, UK, Australia, Canada and global real estate while being more challenging for U.S. large cap, Global, Japan, long/short and infrastructure managers.

The quality factor was the standout performer across most regions, with the growth factor also outperforming. Conversely, momentum, low volatility and value lagged with varying degrees. Value performed better in emerging markets, the UK and Japan. In emerging markets, growth underperformed.

As a result of the reversal during this period, information technology was the best-performing sector, with communications services and consumer discretionary also exhibiting strong returns.

Energy and financials were the worst-performing sectors, due to the twin headwinds of falling energy prices and recessionary fears triggered by the banking crisis. Weakness was also observed in the healthcare, utilities, real estate and consumer staples sectors.

Drawing on our unique relationship with underlying managers, we’ve compiled these and other 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 first quarter of 2023.

Australian equities

Sit and wait

• Turnover of Australian cash equities was 26% lower in Q1 23 relative to Q1 22. ¹ While Q1 22’s turnover was elevated by the Ukraine invasion , decreased turnover is consistent with our observations of little change in portfolios.
• Managers spent the latter part of 2022 increasing the defensiveness of their portfolios, selectively adding to healthcare, gold and insurance names and seeking quality companies overall.
• Within consumer discretionary, managers prefer gaming and education companies, which are more resilient in a downturn than retail and travel. This is consistent with the median manager being above benchmark in the quarter after the February ‘23 reporting season, where there were more misses than upside surprises to expected earnings.
• Managers are expecting that earnings guidance will be revised down in the May confession season , prior to the August ‘23 reporting season. As such, there is a preference for retaining existing positions and only trimming or adding when valuation opportunities arise.

NIMs, not SVB, impact Aussie banks positioning

• Increased competition impacting future net interest margins (NIMs) and expectations of slowing credit growth have impacted views on banks more than Silicon Valley Bank ((SVB)) related concerns.
• Most managers are maintaining their underweight to the sector.

M&A activity heats up

• The first quarter saw an increase in takeover offers for ASX companies, predominantly from offshore companies.
• Managers note the potential for takeovers provides a floor for value companies.

Canadian equities

Managers anticipating economic slowdown

• Managers expect the monetary tightening by both the Bank of Canada and the Fed to cause a recession in both Canada and the U.S. later in 2023.
• Based on the expectation of economic weakness across North America, investors are shifting positioning to emphasize companies with more stable revenue prospects or higher quality, more durable business models within cyclical industries.

Bank industry concerns

• While the Canadian banking industry is much better positioned to weather banking crises than its U.S. counterpart, managers expect a tighter lending environment in Canadian banks as a spillover effect from the Silicon Valley Bank crisis. More conservative lending will pressure banks’ earnings prospects and also exacerbate economic weakness.

Enthusiasm for M&A

• Managers are optimistic about the environment for companies seeking to grow through acquisition. Relatively low valuation multiples across the market create a target-rich environment for strategic buyers, with investors favoring those with a track record of accretive acquisitions.

Copper and lumber are favored segments within materials

• Despite weakening economic sentiment, investors do not expect a severe recession and they are optimistic about copper and lumber when the economy inflects upward. While several commodity industries have tight supply, both copper and lumber have very favorable secular demand prospects.
• Increased demand for copper will be driven by greater electrification and alternative energy, while lumber demand will be driven by housing shortfalls across North America.

Emerging markets equities

China remains an opportunity despite sentiment swings

• Managers are adding selectively to China amid increasing earnings volatility and aggressive market action. This has led to profit-taking among internet names that rerated strongly.
• Hospitality, travel and leisure remain key areas of focus as part of China’s reopening story .

Oversold Latin America sentiment opens selective opportunities

• Higher-quality Brazilian financials are seen as attractive, owing to negative sentiment following the political stalemate after President Luiz Inácio Lula da Silva’s election win.
• The recent market selloff is presenting selective valuation opportunities in the energy sector.
• Mexico is seen as a major beneficiary from near-shoring of U.S. companies. Investors are also increasingly optimistic on the travel sector.

Improvements on semiconductor cycle

• While inventory overhang remains a near-term issue, investors are constructive on the semiconductor and memory cycle, given the clear structural demand from digital infrastructure and AI (artificial intelligence).

India is reminded of governance challenges

• With scandals hitting the Adani Group, managers are seeing opportunities in higher quality competitors that are well placed to take market share.

Saudi Arabia reforms to potentially unlock investor returns

• Despite weaker oil prices, managers see earnings green shoots from Saudi Arabia’s growing privatization and national investments. High-quality banks are expected to be the primary beneficiaries.

Investors look to mitigate geopolitical risks

• Given the uncertainties around U.S.-Russia/China relations, managers have increased exposure to non-China manufacturing hubs, such as Vietnam and India.

Europe and UK equities

The time for banks to shine?

• Q1 brought back memories of 2008, but importantly, it served to confirm that banks have meaningfully evolved since the Global Financial Crisis ((GFC)).
• Higher liquidity ratios, higher capital buffers and more conservative business practices are now commonplace in the industry. This, combined with cheap valuations and industry tailwinds from rising interest rates, make it an attractive area for investors.

Higher interest rates will keep testing the system

• Curing a system addicted to cheap borrowing is no easy task, and it can have extreme consequences for illiquid or highly leveraged businesses. While the average European corporate is well-capitalized compared to 2008, pockets of risk remain in the market.
• The SVB debacle helped highlight that private equity was one of these pockets of risk, but unprofitable growth and real estate could be added to the list. Share prices in these industries have already corrected, but managers expect further downward pressure.

Investors looking beneath the surface in the UK

• UK equities have been garnering increasing attention from global investors based on their attractive valuations. Trading at historically low P/E (price-to-earnings) multiples with an attractive dividend yield, the market is cheap in a developed market context, given it is heavily exposed to global companies with global revenue streams rather than to the UK domestic economy.
• While the UK market has a heavier exposure to value sectors such as energy, materials and financials, these sector biases do not fully explain the valuation discount.
• Having historically been known for its dividend preferences, more UK-listed companies are now turning toward share buybacks to deploy capital at these low valuations, which may provide some underpinning for share prices.

Global equities

Cautious optimism despite a mixed earnings picture

• While profit margins have fallen, cost pressures have started easing, which will allow nominal growth to continue. Managers are looking for opportunities supported by margin expansion.
• Technology companies have derated and look interesting, since businesses are adjusting capital discipline in response to the tighter interest rate environment.
• Managers are being pragmatic on valuations and have taken profits in some of last year’s winners, such as energy.

Reducing tail risks with more defensive exposure

• Given macroeconomic risks, managers continue to reposition some cyclical exposure into defensives and secular stories, e.g., healthcare.
• Managers are also trimming lower quality names for downside protection. Awareness has increased around profitability, capital allocation and competitive moats.

Market volatility triggers idiosyncratic opportunities

• Market uncertainty and fear sentiment has led to dislocated fundamentals, favoring stock pickers.
• Long duration investors remain committed to innovation areas, given continued earnings strength and relative valuations.

Investors shrug off banking worries

• Managers have little exposure to lower-tier banks where recent failures were linked to riskier deposit bases and poor governance. This is not seen as systemic, given the improved health and robustness of financial regulations post-GFC.

Opportunistically adding to emerging markets

• Managers continue to find valuation plays outside of the U.S., namely emerging markets and Asia.

Japan equities

Managers remain calm despite turmoil in the financial sector

• Managers see banking systems in developed countries as well as corporate balance sheets as relatively strong. They believe they’re able to absorb emerging stresses with little systemic risks.
• Some managers have trimmed financial exposure, expecting negative impact to the economy - including banks’ return expectations. Nonetheless, Japanese banks are generally viewed as being well capitalized.

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