In Brief

• As interest rates have moved higher, more signs of stress have appeared in the financial system, and the impact will be felt in the real economy, too. Equity markets have been weak for a year, and at least some bad news is discounted. But we should be prepared for more issues to emerge as the impact of higher rates is felt around the world.
• So far, corporate profits have held up very well after an extraordinary surge in 2021. But margins are now declining for many companies, and we expect weak profits in 2023. Emerging markets may buck the trend as China joins the recovery.
• Our investors have a slightly cautious view of the outlook for equity markets. For the long term, valuations now look very reasonable in most regions and industries. That’s important. But 2023 will clearly be a tougher year as we work through the impact of tighter monetary policy.
• We prefer high quality stocks. We like some industrial companies that face a tougher year but maintain good long-term prospects (the safest names now look expensive). Companies with stressed balance sheets and/or those that have yet to achieve profitability are likely to stay out of favor.

Taking stock

An old market adage tells us that when the Federal Reserve starts raising interest rates, something goes through the windshield. So far in this tightening cycle, the damage has been significant but largely contained to financial markets. Special purpose acquisition companies (SPACs), meme stocks, “growth at any price” stocks and cryptocurrency have all posted spectacular losses, but the real economy has continued to expand, albeit at a much slower pace.

Yet the recent crisis in the U.S. regional bank sector threatens to upend that narrative. At the time of writing, two large institutions have failed at remarkable speed, and the impact on the whole regional banking sector will clearly be negative. We expect lower profit margins, more capital raising and more regulation as a direct consequence of these events.

Regional banks are, of course, an important component of the financial system, and tightened lending standards could hurt a wide range of businesses. Commercial real estate (heavily financed by regional banks) and the private equity and debt complexes look to be likely candidates to struggle under the weight of higher interest rates.

Not all is doom and gloom, however. As China’s economy recovers from the effects of the country’s recently abandoned, highly restrictive pandemic policies, it will continue to boost corporate earnings in that market. A softer official tone toward technology businesses that have been under intense scrutiny could also improve sentiment toward Chinese equities.

After a year of weakness in global equity markets, valuations in most regions do not look very demanding. We know that while these metrics tell us little about returns over the next year, they are important for longer-term investors. The multiples we observe in Europe, Asia and, indeed, many sectors of the U.S. market suggest reasonable returns ahead for patient investors.

We also see a very good chance that diversification beyond the dominant U.S. equity market will help overall equity returns. That has been true of late but was certainly not the case for most of the past 15 years.

Overall, our portfolio managers have a neutral or slightly cautious view on the outlook for equity returns. We strongly prefer quality investments; this is not the time to compromise, and many surprises are likely to be unpleasant. Strong, predictable and profitable business models; experienced management teams; well-funded, conservative balance sheets – these are all attributes that our investors find particularly appealing at this stage of the business and market cycles. But after a year of more difficult returns, some of the most defensive stocks are already expensive, and we need to look beyond the obvious choices to find attractive returns.

Global profits resilient so far, but risks lie ahead

It is worth remembering just how strong profitability has been across almost every region and industry. The extraordinary boom that was unleashed by the fiscal and monetary policies to combat COVID-19 led to a rise of almost 60% in global corporate earnings during 2021. That took profits to record levels, 30% higher than before the 2020 downturn. While revenues grew at a good clip, net profit margins did even better, soaring to 12% in the U.S., for example, vs. a pre-pandemic peak of less than 10%.

So far in the post-pandemic phase, profits have held up pretty well, with companies able to boost prices and keep nominal revenues growing. But those exceptional profit margins have started to erode. Fourth quarter earnings in the U.S. declined 4% on revenues that grew by 5%, and we expect profit margin erosion to persist throughout 2023.

Stock buybacks will help (as they always do), but overall we anticipate U.S. earnings to fall around 4% for the full year (Exhibit 1). We see downside risks to this forecast, given the exceptional levels of margins that companies currently enjoy. Continued wage inflation, higher capital spending and higher funding costs will all weigh on profits this year, even as revenues continue to rise.

Earnings growth is fading after a spectacular boom

Exhibit 1: Corporate earnings, earnings estimates, 2021–2023

Source: J.P. Morgan Asset Management; data as of February 28, 2023.

The picture is similar in other regions, but we highlight some significant offsets. Technology companies are now vigorously cutting costs – an exercise with considerable potential after several years of dizzying growth and hiring. We think many industrial companies can maintain strong pricing power, given high order backlogs and the full impact of government stimulus (including the CHIPS and Science Act and the Inflation Reduction Act) yet to be seen. Overall, we see a muted but not dreadful outlook for earnings.

As we’ve noted, high quality companies that we think we can rely on to navigate this more difficult economic environment are a strong feature of our portfolios. Conversely, we have little interest in businesses with weak balance sheets. Early-stage growth stocks yet to achieve profitability may well continue to struggle, despite dramatic price declines over the past year.

Can Europe keep outperforming?

When we reviewed the performance rankings of different markets and sectors at our recent Investors Quarterly, it was striking to see the country indices for France, Italy and Spain as global leaders over the last year. It has been a very long time indeed since that happened. Over the last 12 months, the MSCI Europe Index is up 8% in U.S. dollar terms, compared with a decline of 7% in the S&P 500 and an 11% decline in the MSCI Emerging Markets Index.

After many years of dull returns from European markets, can this outperformance continue? Our bottom-up research suggests that further relative gains are likely, and our European-based investors are optimistic, too.

Our analysts anticipate pressures on profit margins in Europe this year. But with the helpful impact of fast-growing companies such as AstraZeneca, LVMH and ASML, coupled with a continued surge in profits at the important energy companies, we think European profit margins will strengthen in the years ahead. Our local portfolio managers think that the region is deeply out of favor and very reasonably priced. They also note that European companies are finally buying back stock at a comparable rate to their U.S. peers.

Of course, Europe has not been immune in recent weeks to the nervous sentiment toward bank stocks. Credit Suisse, which struggled for years with poor profitability and a series of mishaps and scandals, was forced into a government bailout and a hurried merger with UBS. We do think the rest of the banking sector is in much better shape following a long period of more stringent regulations and increased capital raising.

Rebounding emerging market profits helped by China reopening

2022 was a miserable year for both companies and investors in emerging markets. Profits fell 15% (in contrast to solid gains in most developed countries), and the MSCI Emerging Markets Index lost 15%. Over the past five years, the index is down 20%.

This picture may be changing for the better. The all-important Chinese economy is now in full recovery mode following the rapid abandonment of highly restrictive anti-pandemic policies at the start of this year. We think that shift will unleash a consumption boom fueled by almost USD 500 billion of surplus saving accumulated during the lockdowns (Exhibit 2). Many Chinese companies were forced to restructure during the past few years, and they are much better positioned to profit in the recovery.

Chinese households have added more than 3 trillion RMB (USD 500 billion) of surplus savings

Exhibit 2: Households accumulative surplus savings

Source: Haitong Securities, National Bureau of Statistics; data as of December 2022.

Outside China, we find plenty of growth across emerging markets. Our research team sees higher profits in India, Indonesia and Taiwan this year. Certainly, emerging markets have proved disappointing for quite a while, and the usual political risks have not disappeared. But with profits outperforming the developed world (for a change) and valuations still at very reasonable levels despite the recent bounce in China, patient investors may well be better rewarded this year.

Exhibit 3 shows the views of our team members around the world. Overall, they remain slightly cautious and emphasize quality in portfolios. Technology finds both supporters and detractors.

Views from our Global Equity Investors Quarterly, March 2023

Exhibit 3

Source: A subset of results is shown from a March 2023 survey of Global Equity Investors Quarterly participants. These responses are taken from a quarterly survey representing 30 CIOs and portfolio managers across global equities.