While global commentators are becoming increasingly negative on global equities, there are still sound opportunities for bottom-up, fundamental investors who are willing to dig a little deeper. This is according to Fabiana Fedeli, Chief Investment Officer (Equities, Multi-Asset and Sustainability) at M&G Investments (UK).
In a mid-year review, she said that the same, two key drivers that preoccupied markets in the first half of the year will continue in the second half. These are ongoing central bank decisions, and the likelihood, timing, and depth of a recession.
“In our view, the Fed is unlikely to cut rates this year, unless there is a deep recession or inflation drops to 2%. Neither of these outcomes is in our base case scenario.”
However, she noted that history has shown that recessions can come with a lag and that the extent of the deterioration of macroeconomic data going forward will be the real determinant of equity market performance. In the US, a broad range of lags of 5-15 months between rate hikes and recessions have occurred since 1965.
“On the surface, global equity markets appear fairly priced for the risks ahead assuming a moderate recession. However, below the surface, there are notable differences not only between regional markets but also between stocks in the same market.” She highlighted the S&P 500 Index as significantly overvalued versus other markets, given the fundamentals.
The US market is almost twice as expensive as other major markets; a premium that has been supported by a perception of higher quality and relatively higher earnings growth. But the justification for this premium is looking less plausible, Fedeli said, particularly versus Europe.
“As the first half of the year wraps up, EAFE companies (Europe, Australasia and the Far East) have delivered more robust earnings and sales growth numbers than those in the US, where we’ve seen the S&P Index deliver year-on-year declines in earnings-per-share growth.”
The breadth of performance has also differed. The recent rally in the US was concentrated in a handful of primarily mega-cap technology stocks. In Europe, by contrast, the strongest rallies were much broader. In addition to luxury goods, pharmaceuticals, industrials, and companies related to the energy transition participated in the rally.
“We stand by our position from the first half of the year that this is not a time for broad strokes investing. Selection is the main driver of alpha, diversification is key, and volatility has to necessarily become our friend.”
Attractive value in Japan
Japan, which is one of M&G Investments’ favourite markets, is starting to attract the interest of other global investors as they begin to realise the growth opportunity Japanese companies present, based on their culture of self-help and corporate reform. “But what is less well recognised is the prospect of wage growth boosting consumption and providing a further potential tailwind for growth in the years ahead.”
“After years of short-lived excitement and false starts, and having eventually fallen off the radar for many, Japan is gaining growing attention. But we still believe that Japanese companies are not fully appreciated and that there are compelling opportunities for active investors.”
China, on the other hand, has a higher risk premium and lower valuations for various reasons, including the tensions with the US. These are unlikely to go away completely, and their impact must be considered when selecting stocks.
However, the two countries are very closely intertwined through trade and neither side wants, nor can afford, a major disruption in the current economic climate. Fedeli is encouraged from a bottom-up perspective as a number of large Chinese companies are doing a good job in terms of margins and profits, and many companies are returning cash to shareholders in the form of buybacks.
Short-term dislocations and long-term opportunities
In an increasingly news-driven market volatility is pervasive, resulting in mis-pricing that can create attractive investment opportunities, she observed. And there are likely to be more ahead as the market reacts to central bank decisions and datapoints that appear to support fears of a deep recession.
Apart from these tactical opportunities, there are companies exposed to long-term themes that will continue to attract capital even in a global demand slowdown. These include infrastructure, innovation (such as AI and healthcare), and the low-carbon ecosystem. “But once again, companies in the same sectors can fare very differently due to differences in exposure, product and pricing strength, and management.”
Overall, the firm maintains a relative preference for non-US equities, where it finds more compelling opportunities from the point of view of valuations and earnings profiles.
“As we move through 2023, we remain diversified, continue to focus on bottom-up, differentiated research to drive alpha, and stand ready to take advantage of tactical opportunities presented by market volatility,” Fedeli concluded.