Our base case timing for a pivot to a sustained upside move in equities is in the second half of 2023, but it all is dependent on the timing of the US rate-hike cycle reaching its peak.
Having endured a volatile 2022 in which many equity markets have at times fallen by 25% or more from their peaks, equity investors are anxiously looking for signs that a broad market recovery is on the horizon. We do believe that equities will begin to sustainably recover in 2023, but we also believe that the pain that equity investors feel will not begin to lastingly subside until mid-year, with the exact timing of the relief tied to the actions of central bankers.
We are currently underweight equities. That said, at their current levels we do not see a lot of potential downside in equity markets, as we believe that most bad news has already been priced-in. Our base case thinking about the timing of a pivot to a sustained upside move in equities is the second half of 2023, but that is dependent on the timing of the US rate-hike cycle reaching its peak. Thinking positively, if inflation is meaningfully reduced more quickly than central banks expect, then the peak-rate timing (and timing of a pivot) could be advanced. Alternatively and more worrying, peak-rate timing could be advanced if employment or economic growth show serious damage from central bank actions.
Against this backdrop we are focusing on Quality stocks, which remain inexpensive relative to historical norms (see Figure 1). Here we look for firms with stable earnings and strong business models — i.e., those that are resilient enough to pass on price increases to customers. With long-term interest rates unlikely to return to the zero or negative levels of recent years, we are also looking for companies that can withstand rising interest rates and effectively operate with less liquidity than they have in the past. Presently, firms with these characteristics are most prevalent in US equity markets.
Figure 1: MSCI World Quality Factor Book/Price Spread Versus Long-Term Average (10 year)
Given the current extremes in valuation caused by falling markets, we also believe that Value stocks will likely outperform when the pivot comes. As inflation and real yields stabilize, we will look to add to equities from outside of the US — especially Europe — which currently have a stronger Value bias. Looking into 2024 and beyond, we are confident that investment in Eurozone equities will be supported as energy issues are resolved and sentiment improves. Notably, however, the UK’s prospects will only improve if the Brexit hangover is treated with a dose of stable government and economic policy, leading the labor market to stabilize.
In emerging markets, we continue to look for signs from China that suggest a stable and clear opportunity for equity investors there. The current weakness of China markets, as well as the strong US dollar, combine to limit equity opportunities in emerging markets.
The equities investing landscape reflects a complex world, so we are also paying close attention to relevant events. A resolution to the Russia-Ukraine War, which is pressuring energy prices and depressing European markets, would be a strong positive catalyst to equity markets, as would clearly constructive economic signals coming out of China. As we write this, neither is evident.
It is a difficult time for equity investors, but challenges always represent opportunities. Investors would do well to be prepared for a market pivot during 2023, and in the meantime we suggest that higher-than-normal volatility can be managed with dynamic asset allocation and/or approaches that include managed volatility and defensive equity strategies. In a time of elevated rates, cash is no longer a drag on a portfolio and provides dry powder for increasing an equity allocation at a prudent time.
We believe that Quality stocks will outperform the broader market, both in the near term and when a rate peak signals an inflection point for equities. Severely depressed equity valuations suggest that Value stocks will outperform as well when sentiment lifts, especially in Europe.
We are keeping an eye on a great many drivers of equity performance, and hope to be in a position to move to a risk-on positioning during 2023. Patience is a virtue that the markets reward.
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