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.


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