Find Opportunities in Discarded Markets

In 2022, rising rates, geopolitical conflict, and sluggish growth pushed global stocks and bonds into a bear market at the same time, for the first time ever.¹ Within global equities, just one third of countries² — and only one sector³ — posted a positive median stock return. Bonds fared even worse. Every country, sector, maturity bucket, and credit quality rating band in the 32,000 bond holdings within the Bloomberg Global Multiverse Bond Index suffered losses.⁴

Now, as a result of this pain, many markets trade well below their perceived fair value — some justifiably, given the confluence of risks. Unfortunately, the three factors inflicting pain at the close of 2022 are unlikely to change in 2023 — not immediately, at least. At some point, though, Fed policy may become less aggressive, and earnings sentiment could find a bottom.

If that happens, sentiment could shift to the healing phase of this cycle, given the market’s forward-looking nature. And some segments thrown out of balance in 2022 may be the first to mean revert in 2023, revealing the hidden value in today’s downtrodden and discarded areas.

Unearthing Value in US Small Caps

Given the broad-based negative returns, some investors might think all markets present value opportunities. But that’s not the case.

For starters, even though US equities have fallen by 16%, they still trade at 17.9 times next year’s earnings.⁵ That’s still above the long-term average of 17.1 times,⁶ and doesn’t indicate broad-based value for contrarian investors looking to zig when everyone else zags.

Outside the US, the valuation case has more merit. Non-US equities now trade at 12.17 times next year’s earnings, 20% below their historical median average of 14.94.⁷ The same is true under a shorter horizon, as US stocks trade on par and at 7% above their 5- and 15-year median levels.⁸ Meanwhile, non-US stocks trade 11% and 12% below their 5- and-15-year median levels, respectively.⁹

This doesn’t mean every US market is rich and any country outside the US, cheap. Comparing multiple fundamental metrics rather than just one gives investors the needed nuance to rummage through the bargain bin.

We calculated percentile ranks using a five-factor ensemble valuation screen¹⁰ analyzing both absolute and relative valuations to the broader global market over the past 15 years. US small caps, followed by emerging markets (EM), screen as the most attractive. All US large caps are the most expensive, including large-cap value stocks — a reflection of their significant outperformance.

EM may be cheap for a reason, as earnings revisions have trended sideways and an 11% decline in 2022 earnings growth is currently projected.¹¹ Not ready to signal a bottom in fundamental sentiment, analysts’ 2023 earnings estimates continue to decline. Next year’s growth rate for EM has dropped to 1.7% from 6.0% over the past three months.¹²

Small caps haven’t witnessed the same degree of negative earnings sentiment. In fact, 2022 earnings-per-share growth is estimated to be 14%, a full percentage point higher than forecasts at the start of the year.¹³ Additionally, 2023 estimates still call for 4% growth, with three of the four quarters expected to show positive growth (unlike EM, where growth is projected to be flat or negative every quarter).¹⁴

Risk aversion helps explain some of the negativity toward small caps from a price return perspective. Small caps are a volatile market segment, and investors dialed down risk in 2022 amid the multitude of macro factors impairing sentiment. This risk aversion rationale is reinforced by the fact that, in 2022, small caps registered their highest average 30-day correlation (93%) to high-beta stocks since 2011 (93.7%).¹⁵ Simply put, anything with a whiff of risk was seemingly discarded.

While risk is still likely to be elevated in the near term, if a policy pivot turns market pessimism to optimism and risk aversion declines, our view is that segments with decent fundamentals and attractive valuations may enter a repair phase more quickly than expensive areas. Domestically oriented US small caps represent one of these possibilities, given their cross-sectional valuation.

Semiconductors Send a Signal Above the Noise

Within US equities, the semiconductor industry was one of the worst performers in 2022. Its high-growth, long-duration profile was impaired by the significant increase in rates. Semiconductors underperformed the S&P 500 Index by 9% after registering positive excess returns in eight of the past nine calendar years.¹⁶ This was the industry’s worst relative performance since 2012, when it fell 10% relative to the market.

Given this dour return backdrop, semiconductor stocks are trading at potentially attractive valuations. On an absolute basis, the current average percentile of the same five-factor-fundamental screen is 36% over the past ten years, as shown in the following chart. Meanwhile, valuations are, on average, in the lower 20^th percentile relative to the broader US equity market.

But beneath the surface, three metrics are in the bottom 5^th percentile:

1. Price to Earnings (P/E)
2. Forward 1-Year Price to Earnings Ratio (P/E FY1)
3. Enterprise Value to Earnings before interest, taxes, depreciation, and amortization (EV/EBITDA)

These percentile rankings are much more attractive than broad-based tech, a sign that semiconductors carry a differentiated profile than the broader sector.

While valuations have re-rated, growth expectations remain elevated. Expected 3-5-year EPS growth has increased from 17.7% at the beginning of 2022 to 18.8%.¹⁷ Compared to the broader Tech sector, this seemingly minor one percentage increase is substantial, as the tech sector saw its longer-term forecasts ratcheted down to 12.9% from 14.6% over the same time frame.¹⁸

The growth also comes off a more profitable base. Of the six other sub-industries within the broader tech sector, the semiconductor industry has the largest percentage of firms (70%) with positive earnings-per-share figures over the past 12 months.¹⁹

Future semiconductor growth could be further supported by the recently passed CHIPS and Science Act, which provides $39 billion for construction of semiconductor plants and $11 billion for semiconductor research and development to be disbursed through 2026.²⁰ The CHIPS and Science Act could add significantly to the momentum in capital expenditures and the ongoing trend of reshoring semiconductor capacity. Announced semiconductor plans have already surpassed $138 billion.²¹

Risks to the semiconductor sector include highly cyclical demand that is strongly correlated to global GDP and the fact that 80% of the industry’s revenue comes from outside the US.²² An upside surprise on growth stemming from a policy pivot and a weaker US dollar (USD) that mean reverts off 20-year peaks²³ could counterbalance the headwinds for semiconductor sentiment and the recent trend of softer, but still positive, sales.

Emerging Market Local Debt and Preferreds: Value in Non-traditional Markets

The dollar’s strength has hurt many markets this year, chief among them EM local debt. The segment is expected to have its worst calendar year return ever of -16%,²⁴ which has pushed the yield on EM local debt to its highest level since the Global Financial Crisis, near 6.7%.²⁵

While a shift higher in yields from central bank policy actions detracted from returns, currency effects were the main culprit as the dollar strengthened and EM currencies fell. Historically, EM local debt returns have had a 94% correlation to the returns on EM currencies, so this trend is no surprise.²⁶

In fact, since 2008, EM local debt has had negative returns in 92% of the months when EM currencies fell (and the dollar strengthened), with an average monthly loss of -2.29%.²⁷ As a result, an allocation into EM local debt is not so much a bullish view on the debt from developing nations, but rather a bearish view on the dollar.

High US inflation, rising US rates, and safe demand have kept the USD well-bid and trading at 20-year highs. Yet, given where we are from a valuation perspective, some near-term mean reversion could occur, particularly if a dip in inflation prompts a Fed pivot. That would be positive for risk-asset sentiment and could reduce the demand on the safe haven dollar.

The softening of the dollar would be net positive for EM local debt, as in the months when EM currencies rallied, EM local debt’s return was positive 86% of the time with an average monthly gain of +2.27%, as shown in the previous chart. And as a result of the demoralizing returns, a potential dollar bear allocation offers a generationally attractive yield that just may be worth the risk.

Preferred securities also have witnessed steep declines, returning -16% this year and pushing yields over 6% for the first time since 2013 (except for the brief interval during the COVID-19 crash).²⁸ And not surprisingly, the average price on preferreds has dipped below 85,²⁹ the first time that preferreds have traded at this large of a discount to par (except for the brief interval during the COVID-19 crash).

Part of the reason for the sizable drawdown is that preferreds carry a duration of over seven years.³⁰ Preferreds are also equity sensitive, given that they are hybrid securities with features of both bonds and stocks. The underlying common equity on preferreds fell almost -8% in 2022, on average.³¹

The weakness, however, is not a result of any outsized credit risk, as the composite quality rating on preferreds is investment-grade.³² Primarily issued by banks and insurance companies, preferreds count toward regulatory capital requirements — and banks issue preferreds to help maintain their required capital ratios. And as of the latest stress tests, major financial institutions were given a clean bill of health, indicating that the underlying fundamentals for the largest sector of issuance are reasonably sound.³³

Even with higher rates around the world, there is no sector, credit quality, or rating band in the Bloomberg Global Aggregate Bond Index that has a yield over 6%.³⁴ Preferreds, therefore, offer a deeply discounted investment-grade yield opportunity and also may be able to participate in any risk aversion reversal in the equity market. The attractive entry point serves as a bit of a backstop and balances the risk that the Fed’s policy pivot doesn’t come soon or isn’t as benevolent as many expect.