In order to boost the resilience of equity allocations against this backdrop, we believe that investors should focus on a combination of high-quality balance sheets, strong dividend payers and regional diversification.
Rising hopes of a Goldilocks scenario have been very supportive for stocks this year. The strong rebound since last September’s market trough has been almost entirely driven by multiple expansion, while earnings expectations have flatlined. Europe ex-UK is the one major exception, where the rally has been fuelled by a combination of rising valuations and improved earnings expectations as the risks of an energy supply crunch have faded.
This might be a matter of market hope over earnings reality. An economic downturn still seems the most likely scenario to rid developed economies of their inflation excesses. But lower inflation, by definition, means lower corporate pricing power.
In order to boost the resilience of equity allocations against this backdrop, we believe that investors should focus on a combination of high-quality exposures, strong dividend payers and regional diversification.
Quality is king
Amid heightened uncertainty, our highest conviction view within equities is that markets will reward companies with stronger quality credentials, such as robust balance sheets and management teams with deep experience through multiple cycles. While these characteristics may always sound attractive for stock pickers, the last bull market saw higher quality stocks trade largely in line with the broad US market for an entire decade. History suggests that a quality focus performs most strongly during periods when the economy weakens.
It is also important to note that an up-in-quality approach does not exclusively equate to growth stocks. Some of the mega-cap growth players will fit a definition of quality thanks to their robust balance sheets, but equally we see high quality opportunities in more value-tilted sectors such as energy and select large-cap financials. The wide gap in valuations between growth and value sectors relative to history is another reason to ensure that portfolios are well balanced across both styles. From a size perspective, a focus on stronger balance sheets generally points to a preference for large caps over smaller counterparts.
Dividends for defence
A tilt towards dividend payers may also help to buffer equity portfolios from more volatility ahead. Payout ratios are yet to recover to pre-pandemic levels across most major regions, after many companies were forced to pause dividends during Covid-19. This leaves room for companies to maintain dividends even if earnings do soften.
Strong dividend payers are often found in more defensive sectors such as healthcare and utilities that typically exhibit lower beta to the broad market, unlike some of the more cyclical growth sectors where cashflows are more frequently reinvested into the business instead of being returned to shareholders. Dividend yields in the emerging markets look particularly attractive, standing close to their widest gap to developed markets in over 20 years.
Diversified across regions
Given the uncertainties, we’d caution against positioning portfolios with too much concentration in any one single equity region.
Our primary concern about the US market relates to how concentrated it has become. In the first five months of 2023, the top 10 stocks in the S&P 500 returned just under 40%, while excluding the top 10, the S&P 500 actually declined over the same period. With the exception of the pandemic, the gap between the valuations of the top 10 and the rest is at its widest level since 2000.
Markets may be betting on either extraordinary profits in tech thanks to recent developments like AI or, the hope that tech will generally prove defensive in the event of economic turbulence that sees interest rates return to very low levels.
We’re cautious to place too much weight on the view that the sector’s earnings will prove countercyclical in the event of a US recession. A look back in time shows that this is rare. More diverse business models and much stronger balance sheets suggest that it’s unreasonable to compare the situation today to the bursting of the dot-com bubble in the early 2000s, when tech earnings fell much more heavily than the broad index. Yet we are also sceptical that tech stocks can repeat their feat of 2020 and see profits tread water at a time where earnings come under pressure across many other sectors, particularly in some of the more economically sensitive parts of the sector such as hardware. Even in the most optimistic scenarios for the evolution of artificial intelligence over the next decade, a shorter-term pullback in spending from both consumers and businesses as the economy weakens appears likely.
Investors looking to diversify US holdings may wish to allocate more to Europe than they have in the last decade. Cheaper multiples and stronger dividend yields in the UK and Europe ex-UK should fare relatively better versus the US in the scenario that equity valuations come under pressure. Europe’s departure from its low rate, low inflation rut also bodes well for the region’s prospects over the medium term, as we highlight in our recent piece.
Our base case of a slowdown in the global economy would typically bode badly for emerging market stocks relative to developed market counterparts, yet there are reasons why this relationship may not hold this time round. The first is valuations: emerging market stocks already trade at close to a 30% discount to developed markets on a 12-month forward earnings basis, and many currencies screen as cheap relative to the US dollar. The second is monetary policy: with several emerging market central banks having frontloaded their hiking cycles in 2021, cooling inflation this year is now opening up the potential for rate cuts that would support economic growth.
China’s post-Covid recovery was expected to provide support for the broad emerging market region, although after a very strong first quarter, economic data has more recently underwhelmed investor expectations. Pockets of the services sector are rebounding strongly but the manufacturing sector remains weak, emphasising the need for an active investment approach to tap into pockets of stronger earnings growth. Potential catalysts for an improvement in broad market sentiment include Chinese policymakers providing greater economic support, a rebound in private sector confidence and investment, and/or dissipating geopolitical tensions.
Japanese stocks have enjoyed a strong run relative to other regions this year. While green shoots in the economy are emerging with inflation and wage growth picking up, our optimism is tempered by the prospect of either yield curve control adjustments or a global recession leading to a stronger yen that would weigh on Japanese companies’ foreign earnings.