Investment Outlook - Market Update
After a relatively challenging year in 2022, the first six months of 2023 saw positive returns for global equity markets. This, despite continued macro concerns with core inflation remaining stickier than hoped for, scant evidence to prove the most anticipated US recession had arrived and all compounded by the dramatic collapse of some US regional banks during the period. Central banks continued to raise interest rates and were also forced to further raise expectations for future increases. During the first six months, equity investors generally turned a blind eye to such fundamentals and market headlines were dominated with a new great ‘ hype’, investing in the wonders of Artificial Intelligence (AI) and so driving a new frenzy that pushed equity markets and technology in particular to new levels.
The macro scenario remains entirely consistent with our thesis since Autumn 2021, that a material ‘regime change’ lay ahead for global investors that may last years. We do expect that, inflation will remain stickier and at more elevated levels than the prior decade, which will keep interest rates and bond yields at higher and more normal levels. Such a ‘higher for longer’ interest rate environment should impact market returns and how markets behave. Despite a somewhat bizarre and very narrowly driven equity market during the first half, we continue to expect equity markets will rotate and refocus again on economic fundamentals over coming quarters.
From a macro perspective we are undoubtedly late cycle. We note that this economic cycle has proven itself more resilient than consensus expected. Economic recession has certainly been delayed and some investors who wonder if it will be avoided completely, despite material rate rises to-date! While evidence of a slowdown in manufacturing economies emerged this has been more than offset by strong service economy and labour market strength. Against this background, equity and bond markets will we believe, struggle to make progress. For the coming quarter, a large focus should re-emerge on company earnings releases. Equity investors will be particularly focused on actual earnings reports as well as how executives are describing their current and expected operating environment. Also, top line sales forecasts as well as cost items such as input prices, labour costs etc will be important.
The KBI investment team remain vigilant, focusing on both our top-down macro analysis and in particular a focus on bottom-up company analysis. While expecting the global market environment to remain uncertain and volatile, we will maintain a focus on building balanced portfolios with a mindset towards downside protection, as was the case during 2022.
Asset class outlook:
At an aggregate valuation equity markets are now more expensive, having re-rated again over the past 6 months. Market multiples have expanded in excess of earnings growth and are now at an aggregate level trading greater than historic averages, Regions such as European or Emerging Market equities present better value at present compared to the broad global market. We believe risks are to the downside with respect to consensus earnings forecasts for 2023 and especially should economic recession take hold.
During the most recent quarter, the market has rotated back to ‘in particular technology stocks, with AI related names dominating. We certainly believe that there are large areas of the broader equity market that have been overlooked where fundamentals have remained attractive. We expect that the rotation within equity markets that started during late 2020, will once again resume favouring for example, value rather than growth stocks and sectors, as well as higher dividend paying ones.
Bonds as an asset class having experienced their worst year since 2008 during 2022, have continued to struggle so far in 2023. They have been volatile from quarter to quarter while reacting to market headlines, be they macro-economic or with respect to systemic issues such as the collapse of some US regional banks during the first quarter
Despite continued central bank rate rising and consistent with our regime change thesis, we remain in the higher for longer camp with respect to interest rates and bond yields. Even if rates are close to peak, the regime has changed. We believe bonds remain relatively poor value and while yields have risen materially since 2021, they have done so from historically low levels and may rise further driven by sticky inflation and a realisation that early rate cuts may not occur either.
Risk wise, we are monitoring corporate bond markets for any signs of distress at a company or indeed sectoral level, as the cost of funding has increased sharply and a less positive growth outlook lies ahead. At this stage corporate bond spreads are not indicating any material signs of stress and might therefore be vulnerable.
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