Equities: Problems at the margins

Margins are our key concern as firms are unlikely to have the pricing power they did in times of bumper consumer demand.

The resilience demonstrated by the global economy in 2023 helped to deliver positive returns for equity indexes in all major regions, but the drivers of these returns have varied significantly. Japan is the standout in local currency terms (although much less so in sterling or euro terms), benefiting from a significant re-rating.

These moves leave most major equity markets looking neither cheap nor expensive heading into 2024. The US continues to trade at a major premium to others, but this is primarily driven by the megacaps, some of which have continued to deliver on what had appeared to be elevated earnings expectations. When stripping out the top 10 names, S&P 500 multiples move from 19x 12-month forward earnings to a more reasonable 17x.

The question is whether these valuations are flattered by overly optimistic earnings expectations. Looking at 2024 consensus forecasts, the 11% earnings growth currently expected for the US market stands out as high. Margins are our key concern, as firms are unlikely to have the pricing power they did in times of bumper consumer demand. Yet current analyst forecasts see US margins rising back towards record highs in 2024, and staying close to record highs in the UK and Europe.

The picture for stocks looks more challenging on a relative basis versus credit. Over the past 10 years, developed market equity earnings yields have on average been around 300 basis points higher than the yield available on developed market, BBB-rated corporate credit. Today, that gap is less than 30 basis points.

Identifying opportunities

Our highest conviction view across equity markets is a focus on higher quality stocks – those with robust balance sheets, proven management teams and a stronger ability to defend margins. Naturally some of these will be found in the technology sector, but there are also good examples in more cyclical sectors such as industrials and financials, as well as more traditionally defensive sectors such as healthcare.

We see merit in a balanced approach between growth and value styles. Market dynamics on this front in 2023 have been fascinating. A rising yield environment typically favours value sectors over their longer duration growth counterparts, and this has played out in Europe, Japan and emerging markets. The US is the only major market where growth has beaten value this year, making the outperformance of megacap tech that much more remarkable but also raising some questions about the sustainability of this trend. If a more benign macro scenario prevails, we would expect this to be relatively more positive for value-tilted sectors.

Income strategies are another component of an equity strategy with firmer foundations. Despite potential downgrades to earnings expectations ahead, we think that low payout ratios and solid balance sheets should still leave management plenty of room to return cash to shareholders.

From a regional perspective, European stock valuations look reasonable in absolute terms but compelling relative to the US, with a 30% discount to the S&P 500 – equivalent to levels last seen in the aftermath of the financial crisis. This is not just down to sector composition: European companies trade at an above average discount across many sectors at present.

While the European macro environment has clearly been weaker than the US this year, it does appear that much of this negativity is now reflected in prices, particularly when considering that European indices only generate 40% of their revenue domestically. Conversely, for the US market to deliver another year of outperformance versus its European counterparts, a lot will be riding on the “super 7” largest stocks, who will need to deliver on elevated earnings expectations.

The bull case for the UK is unlikely to be anchored around a major re-rating – the market is indeed cheaper than many others but this has been the case for some time and the catalysts for a turnaround are not obvious. Instead, the relative attractiveness of the UK is likely in its defensive characteristics. The FTSE 100 has the highest dividend yield of any developed market, UK stocks offer a relatively low beta to global stocks, and a high weight to the energy sector could prove a useful diversifier if higher oil prices challenge the disinflation narrative.

Japanese benchmarks have been helped by surging buybacks and hopes that the Japanese economy is out of its low growth, low inflation funk. However, the currency outlook remains the key risk as the Bank of Japan edges further away from yield curve control. Given the extent of the rally to date, we are cautious on the prospect of further significant upside from here.

In China, recent fiscal stimulus should help to put a floor under the growth outlook, supporting consumer confidence and earnings. From a valuation perspective, again it appears that much of the negative macro newsflow is well reflected in prices, with multiples having completed a round trip over the past 12 months. In the absence of a big stimulus package, worries about the property sector and/or the geopolitical outlook will likely need to ease for the market to re-rate.

In sum, with still elevated uncertainty around the path for the economy in 2024, a regionally diversified approach appears prudent. In the US, mega cap tech will need to continue to beat an ever-higher bar when it comes to elevated earnings expectations. A softer landing for the economy is likely to benefit more cyclical regions such as Europe and emerging markets, while in the event of a deeper downturn, the more defensive characteristics of the UK market may come to the fore.



09fa231511135526
The Market Insights programme provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the programme explores the implications of current economic data and changing market conditions. For the purposes of MiFID II, the JPM Market Insights and Portfolio Insights programmes are marketing communications and are not in scope for any MiFID II / MiFIR requirements specifically related to investment research. Furthermore, the J.P. Morgan Asset Management Market Insights and Portfolio Insights programmes, as non-independent research, have not been prepared in accordance with legal requirements designed to promote the independence of investment research, nor are they subject to any prohibition on dealing ahead of the dissemination of investment research.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professional, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not a reliable indicator of current and future results. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. To the extent permitted by applicable law, we may record telephone calls and monitor electronic communications to comply with our legal and regulatory obligations and internal policies. Personal data will be collected, stored and processed by J.P. Morgan Asset Management in accordance with our privacy policies at https://am.jpmorgan.com/global/privacy. This communication is issued by the following entities: In the United States, by J.P. Morgan Investment Management Inc. or J.P. Morgan Alternative Asset Management, Inc., both regulated by the Securities and Exchange Commission; in Latin America, for intended recipients’ use only, by local J.P. Morgan entities, as the case may be.; in Canada, for institutional clients’ use only, by JPMorgan Asset Management (Canada) Inc., which is a registered Portfolio Manager and Exempt Market Dealer in all Canadian provinces and territories except the Yukon and is also registered as an Investment Fund Manager in British Columbia, Ontario, Quebec and Newfoundland and Labrador. In the United Kingdom, by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other European jurisdictions, by JPMorgan Asset Management (Europe) S.à r.l. In Asia Pacific (“APAC”), by the following issuing entities and in the respective jurisdictions in which they are primarily regulated: JPMorgan Asset Management (Asia Pacific) Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited, each of which is regulated by the Securities and Futures Commission of Hong Kong; JPMorgan Asset Management (Singapore) Limited (Co. Reg. No. 197601586K), this advertisement or publication has not been reviewed by the Monetary Authority of Singapore; JPMorgan Asset Management (Taiwan) Limited; JPMorgan Asset Management (Japan) Limited, which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number “Kanto Local Finance Bureau (Financial Instruments Firm) No. 330”); in Australia, to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Commonwealth), by JPMorgan Asset Management (Australia) Limited (ABN 55143832080) (AFSL 376919). For all other markets in APAC, to intended recipients only. For US only: If you are a person with a disability and need additional support in viewing the material, please call us at 1-800-343-1113 for assistance.
Copyright 2023 JPMorgan Chase & Co. All rights reserved.
Image Source: Shutterstock