JUSA - October 2022 Equity Market Outlook: Market Volatility Expected To Persist

Summary

• With inflationary pressures and recessionary fears remaining top-of-mind, equity managers see no short-term end to the bumpy ride in markets.
• One of the key risks cited by equity managers in our third-quarter report is the possibility of inflation remaining stuck at high levels.
• Overall, the third quarter proved to be yet another challenging one for equity markets, with almost all markets ending with negative returns in U.S. dollars and local currencies.
• Managers are cautiously positive regarding the outlook for the Chinese economy.
• Recent market volatility is unlikely to disrupt the European focus on building out green infrastructure and increasing sustainable energy production.

Could this year’s topsy-turvy ride in markets calm down during the final months?

The answer: Probably not, according to the results from our third-quarter equity market outlook. Amid concerns over persistently high inflation, hawkish central banks and geopolitical instability in Europe , most equity managers expect market volatility to persist through year-end.

The outlook also shows that with inflation still high, managers are continuing to favor sectors of the market that offer a natural hedge and downside protection—and will likely keep doing so until signs emerge that inflation is coming under control. Broadly speaking, managers also see non-U.S. equities as more attractive than U.S. equities , due to cheaper valuations and an expectation that the U.S. dollar will begin weakening once the U.S. Federal Reserve (Fed) pivots.

One of the key risks cited by equity managers in our third-quarter report is the possibility of inflation remaining stuck at high levels. This could lead to a more aggressive slowdown in global growth as central banks continue aggressively hiking rates, which in turn could trigger a deeper-than-expected recession. At the moment, however, most managers still believe that a mild recession is the most likely outcome, particularly for the U.S.

Overall, the third quarter proved to be yet another challenging one for equity markets, with almost all markets ending with negative returns in U.S. dollars and local currencies. The exceptions were some emerging markets countries—such as Brazil—that aggressively hiked rates earlier in 2021 and is already seeing inflation correcting while also benefiting from the reopening trade. Other commodity exporters—such as Australia—also benefitted from the current environment posting positive returns in local currency.

The third quarter did prove to be a more favorable environment for active managers in Emerging Markets, Japan, Australia, Canada and Global Real Estate/Infrastructure, while being significantly more challenging for Global, Global ex-U.S., U.S. large cap, U.S. small cap, Europe and UK managers. The UK government’s announcement of planned fiscal policies added to market volatility toward the end of the quarter, ultimately costing Prime Minister Liz Truss her job in October.

Notably, the growth and quality factors generally fared better during the third quarter, while the value factor underperformed across all regions. The exception to this was in emerging markets, where growth and value both underperformed while the low-volatility, momentum and small cap factors outperformed. Overall, outside of emerging markets, style remained a driver of performance dispersion.

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 third quarter of 2022.

Australian equities market

Concerns for company earnings in first half of 2023

• Managers have described the August company results reporting season as benign and a sideshow, noting that macroeconomic news drove share prices in the volatile quarter. As a result, portfolios remain largely unchanged.
• Expectations are that increased interest rates and higher inflation will cut into profits in the first half of the 2023 calendar year, where managers expect consumer demand and company margins to fall.
• Managers are preferring companies which can protect margins in inflationary environments and/or are exposed to structural growth. Balance-sheet strength is a key requirement for selected names. They are wary of consumer discretionary names, with the exception being those in the gaming and alcohol sectors, which are considered more defensive.

Turning positive on China

• Managers are cautiously positive regarding the outlook for the Chinese economy, believing that there will be less COVID-19 lockdowns in the future and more fiscal stimulus, which would improve consumer and industrial activity. This supports positioning in the resources sector, which they expect to outperform other sectors.

Future-facing metals theme strengthens

• Resource companies which are mining materials used in electric vehicles (EVs) and renewable energy production continue to be a favored pick by managers. Managers have increasingly been adding to this theme, while others are maintaining existing exposures and looking to add based on further volatility.
• Managers note that stock selection is paramount, and continue to select low-cost producers, with quality assets and strong balance sheets. Lithium miners were called out as being overpriced, as managers believe the market is ignoring production risks.

Canadian equities market

Recession fears continue to drive manager positioning

• Managers are mindful that the Bank of Canada, like other central banks, is committed to a path of raising rates in order to control inflation. This monetary policy is likely to cause a recession, and as such, managers have been cautious about increasing exposure to economically sensitive companies.
• Investors have been reducing risk and are very selective in financials, given the high leverage of the Canadian consumer and the mortgage-heavy loan books of the banking segment.

Barbelled approach to consumer discretionary

• Within the consumer discretionary sector, managers are positioning toward companies that serve either the higher-end consumer or the lower-end consumer, while avoiding the mass-market consumer.
• Consumer companies catering to the higher-end consumer are preferred, since that segment is less likely to have a decline in spending during periods of economic weakness.
• Companies selling into the lower-income consumer segments also benefit from the trade- down of mid-income consumers who become more cost conscious. As a result, managers see mass-market consumer discretionary companies as the most at risk.

Continuing opportunity in energy

• While energy stocks lagged in the third quarter during commodity price retrenchment, managers continue to be favorably disposed to the sector.
• This is because valuations are compelling, balance sheets are generally healthy for Canadian energy companies and businesses should benefit from continuing momentum, given the global commodity supply/demand imbalance.

Emerging markets equities

Positioning for China recovery while timing remains uncertain

• With the Communist Party leadership’s confirmation in October, as well as advancing vaccine tests, investors anticipate lockdowns to further ease, as signaled in Hong Kong. There nonetheless remains uncertainty with regards to the timing of this and broader impacts following the conclusion of the Party Congress and future policies. Travel and consumer-related names are expected to benefit from economic normalization.
• Managers see attractive opportunities among internet names, with growth managers looking to top-up on positive earnings revisions. Value managers are also increasingly constructive due to cost cuts and margin effects.
• Value managers are also picking up dislocated property service businesses impacted by the broad sector-related selloff.

The cusp of a new commodity cycle

• Managers remain positive on commodity producers such as Indonesia, Mexico and Chile, as they benefit from green metals demand and strong earnings upgrades.

Softer technology industry dynamics

• Across investment styles, managers are increasingly cautious on Taiwan and South Korea, given cyclical recession risks and slowing hardware demand, particularly in consumer technology. Value-sensitive managers see attractive opportunities in memory names, given cheap valuations and consolidated pricing power.

Brazil emerging from inflationary pressures

• With inflation coming under control, market sentiment is increasingly positive in Brazil, with expectations of future rate reductions. Former President Luiz Inácio Lula da Silva is expected to win the presidential election on Oct. 30, with markets reacting positively.

Middle East: Rapidly growing financial hub

• Investors increasingly see opportunities in Saudi Arabia banking on the back of elevated oil prices, which are providing strong macroeconomic tailwinds for stronger spending and credit penetration.
• In conjunction with policy support, United Arab Emirates commercial property is becoming an attractive growth opportunity, with urbanization projects and infrastructure investments.

Europe and UK equities market

High inflation is squeezing both UK consumers & businesses

• Fears around the impact of rising inflation on consumer discretionary spend are weighing heavily on retailers, travel and leisure, home construction and other domestically focused companies. Companies that are unlikely to be immune from these pressures are being sold off.

UK volatility is presenting medium-term opportunities

• Volatility is occurring not only in cyclicals with earnings risk. There are many relatively defensive, low-beta companies that have also been significantly derated that managers are taking advantage of, such as defense companies and consumer credit-rating agencies.

Sterling weakness

• Large UK multinational consumer staples and energy companies are benefiting from the strong dollar and are also seen as better able to cope with a stagflationary environment.
• We have already seen several news bids for UK companies, and take-over activity is expected to accelerate, given the increasingly attractive exchange rates.

More pain to come for quality

• While the more cyclical and value areas of the European market remain attractively valued, the higher quality segment remains expensive despite degrading long-term visibility and shifting consumer demand.

Green capital expenditures remain a priority

• Recent market volatility is unlikely to disrupt the European focus on building out green infrastructure and increasing sustainable energy production. Managers believe fiscal policy will remain supportive toward these industries.

Global equities market

Market volatility expected to persist

• Managers expect that global markets will remain volatile in the near-term, given ongoing geopolitical instability in Europe, inflationary concerns in the U.S. and slowing growth in China.

Increasing opportunities outside of the U.S. market

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