The end of irrationality: 2023 Global Equity Outlook

2022 was a tough year for investors. With multiple forces interacting simultaneously, from high inflation and war in Ukraine, to volatile energy prices and wild market swings, uncertainty is at its highest point since the Global Financial Crisis. Unlikely events, such as the crash in UK government bonds, further complicated the picture. But what is clear is that the rising tide that lifted all boats has gone out.

Without the tailwind of easy money, the next decade will be a departure from the past. Aggressive central bank tightening this year and fears of a recession gave way to equity declines, although recent earnings reports signaled that the economy is stronger than investors expected, and consensus expectations are for 7% EPS growth in the next 12 months. Considering the median earnings decline during recessions in the last 30 years was in the low to mid-teens, we think today’s consensus numbers are optimistic.

Given expectations that the majority of rate hikes in the US have occurred, stock performance going forward should be more closely tied to earnings, which marks a healthy dynamic. Still, there are opportunities in stocks that have been derated. Meaningful dispersion in earnings trajectories across sectors, industries, and companies in the year ahead will require a disciplined approach.

The US consumer remains healthy

The US consumer has boosted the global economy in recent years, aided by fiscal stimulus and accommodative monetary policy. Recent headlines around low personal savings rates and record levels of consumer debt may be alarming. Consumer spending has slowed but the unemployment rate will be a key factor in determining the economic health of the US consumer. In most previous recessions, the increase in unemployment has generally not been more than 2 percentage points. Barring a deeper crisis, should US unemployment increase from 3.5% to around 5%, it would still be relatively low in a historical context. Further, US consumers’ largest monthly expense is their mortgage, and many have locked in favorable 30-year fixed rates. Consumers should have the ability to increase spending in aggregate, although spending patterns may shift away from discretionary products and services. 

Opportunities in the tech sell-off

Despite continuing pressure on economies next year, the sell-off has increased the attractiveness of certain blue-chip names. An increased focus on costs at Alphabet and Amazon, combined with growth potential, could make them even more prodigious free cash flow generators. In contrast, semiconductors are likely to be challenged as growth in the US and Europe slows. In some businesses tied to PCs and smartphones, multiples have contracted but earnings still have room to fall.

There is clear bifurcation in the emerging market internet space. Profitless players like Sea, Southeast Asia’s largest internet company whose business includes Garena and Shopee, have witnessed concerns around their business models. Despite stock price falls of 70%-80%, companies without sustainable business models still trade at high valuations and we expect they will continue to struggle. Profitable players such as China’s JD.com, should continue to perform well after taking steps to manage loss-making divisions and improve operating efficiency. Meanwhile, Korean internet business Naver has been much slower to do so and is struggling with capital allocation issues as a result of its acquisition of Poshmark. Focusing on companies that are strategically improving margins and outlooks for profitability will be more critical in the coming year.

COVID recovery boosts productivity and health care

Growth is returning to pre-COVID levels with the resumption in travel and the return of on-trade¹ consumption. Productivity surged at the start of the pandemic due to the accelerated adoption of new technologies, new ways of working, and digitization, but has been negative in recent quarters. Nevertheless, where in-person activities and business functions normalize, we expect to see productivity gains.

An end to COVID disruption will also be positive for certain health care stocks. Postponed procedures and preventive care should continue to come back to the fore, as will a focus on basic health care and catering to an ageing population. Quality health care companies with structural growth drivers should perform well, particularly those with products or services that are in increasing demand. In addition, it may be underestimated that as a result of COVID, some long-term health trends might be even worse now than before.

Europe contends with energy challenges as shift to low carbon accelerates

Europe’s structural problems – an over-regulated economy and declining population – have been exacerbated by the energy uncertainty. Europe is facing three simultaneous energy challenges in 1) securing alternative energy sources, 2) limiting price impact on consumers while 3) simultaneously meeting emissions ambitions. In 2021, Russia accounted for about 40% of EU gas imports and about 25% of its oil. But that reliance is not evenly spread, with greater consumption of Russian gas in Germany and Poland than in France. The continent is also at risk of further security breaches and other supply disruptions that could put it back into a supply crisis.

Despite a temporary shift back to dirtier fuels, such as coal or lignite, the Repower EU plan aims to phase out use of Russian fossil fuels and accelerate the energy transition. However, on greenhouse gas emissions Europe is ahead of the curve and now only accounts for around 7% of global greenhouse gas emissions compared to 14% for the US and 31% for China, so initiatives to lower its domestic footprint are limited on a global scale. Regarding climate change, Europe faces further pressure of supporting less wealthy countries in building out low emission economies and strengthening defenses against the physical impacts of long-term shifts in temperatures and weather patterns.

Given the weak outlook, we avoid businesses linked to domestic European economies, such as local retailers, banks, and cyclical, capital-intensive business in the energy or materials sectors. Instead, we focus on global franchises that are domiciled in Europe, such as top global luxury brand Hermes, or Nestle, the largest global consumer brand in food and beverage. With costs in local currency but a large exposure to the US economy, multinationals can benefit from USD strength. While currency volatility will continue, long-term dollar strength is unlikely to diminish given the robust US economy and its independence in food and energy.

Emerging markets: India and Indonesia poised for continued growth, Brazil moving in the right direction

Rising rates in the US and a stronger dollar are typically negative for emerging markets. Despite faster economic growth, emerging markets have underperformed developed markets again this year. Looking under the hood, there has been a bifurcation in emerging markets performance. Even considering currency depreciation, key EM markets of Indonesia returned 6%, India was down by only 5%, and Brazil was up 11% all in USD terms. However, China was down 31% and the exit of Russia, roughly 5% of the MSCI EM Index, weighed on returns. Excluding China and Russia, emerging markets would have significantly outperformed the US.

In India and Indonesia, fiscal stimulus has been more moderate than in developed markets, central banks have been prudent with monetary policy, and the countries have kept inflation under control. Consumers are underleveraged and credit growth is improving. Income growth in India’s urban markets is ahead of inflation and the IT sector is performing well. Importantly, both countries’ currencies have held up better than expected, despite sharp US rate rises and USD strength. As US interest rate expectations peak, those currencies may outperform in the next 18 months.

Indian structural reforms, such as the implementation of a goods and services tax, enhanced bankruptcy law, and the clean-up of weaker financial institutions, were important but also headwinds to growth over the last five years. With the benefit of these reforms and a stronger banking system, Indian GDP growth is forecast to be 6-7% in the coming 12 months, while non-performing loans in banks have reduced significantly. Indonesia, similarly, has invested in infrastructure, forced commodity businesses to invest in value-add downstream manufacturing, and is benefiting from offshoring from China, which is helping Southeast Asian countries in general. We expect these growth drivers in India and Indonesia to continue in the medium term.

Rising commodity prices have been a tailwind for Brazil, helping lift projections for GDP growth to 2.5%-3% for this year. The election of leftwing Luiz Inacio Lula da Silva as president occurred with a peaceful transition. Concerns are shifting to fiscal policy and the potential for increased social security payments. However, Brazil’s congress has moved further to the right, meaning any plans are likely to be watered down. Political headlines change daily, and Brazil remains a volatile market, but ultimately it is moving in the right direction.

Beneficiaries of supply chain shifts

Some investors underestimate China’s manufacturing position – replicating it elsewhere will be difficult and take time. Supply chain shifts are happening but will be gradual. Vietnam is well-positioned to be a long-term beneficiary thanks to its young and highly educated workforce, as well as its economy that has geared up for semiconductor and apparel manufacturing. Indonesia and Malaysia have benefitted more incrementally. India is increasing its domestic manufacturing through its Product Linked Incentive (PLI) scheme, offering incentives on incremental sales of goods manufactured in India.

Large tech companies looking for semiconductor suppliers are focused on manufacturers with strong competitive advantages, high levels of efficiency, and the ability to produce leading edge technology, favoring Taiwan and China. But industries that rely more on workforce demographics and lower cost labor, in Indonesia, Vietnam and Mexico, can benefit from supply chains moving offshore.

Property sector and COVID, the two biggest drags on China this year

The crackdown on leverage among property developers has exacerbated China’s real estate crisis. With a significant number of projects incomplete, the problem is somewhat bigger than reports suggest and there is still concern about leverage in the broader economy. Given relatively moderate government stimulus, it will take a long time to stabilize the property market even after the changes announced at the recent Congress of the Chinese Communist Party (CCP). We remain cautious about a recovery in property and banking, as well as basic materials tied into those sectors.

China’s Zero-COVID policy, which was harshly implemented this year, should continue in the short term. However, the government’s announcement of 20 measures to ease COVID restrictions include reduced quarantine times for close contacts and overseas arrivals, a shift towards containment, and boosted vaccination efforts. This has increased expectations that the government will move towards a reopening in 2023. We are more positive on companies that will benefit from a reopening and believe the market will look through future short-term lockdowns.

Significant improvements in margins at companies including Yum China and JD.com, even in the face of ongoing lockdowns, have been underappreciated by the markets. Yum China reported a 400 bps beat on margins, almost returning to pre-COVID levels, and JD.com reported a 200 bps improvement in margins, doubling earnings and beating consensus by 40% in the recent 3Q earnings. Any improvement in the top line could magnify an earnings recovery in 2023.

China incentivized to achieve net zero ambitions

Often described as “the workshop of the world”, China has become the world’s largest carbon emitter given its manufacturing exports combined with its own consumption. The country has a natural incentive to improve performance because many of its own coastal cities, where substantial manufacturing and population are based, face increased risk of flooding from climate change. The government aims to maximize carbon emissions by 2030 and reach net zero by 2060 – ten years later than the 2050 date the IPCC estimates the greenhouse gas budget (in the atmosphere) will be reached, if global warming is going to be limited to 1.5°C.

China is on the path to electrification with massive rollouts in wind, solar and nuclear power. The replacement of old coal plants with newer, more efficient ones will also improve its carbon footprint. Other initiatives include carbon trading and development of carbon capture and storage. The costs will be high and the targets challenging, but we believe that China is motivated to achieve its goals – timing rather than inclination seems to be the challenge.

Businesses increase focus on getting to net zero

Not only are countries targeting net zero, but many companies are expressing goals to become carbon neutral. Investors will need to assess the aggressiveness and achievability of their timelines. To that end, Europe has been driving improvements in the amount and quality of data available on environmental issues, but there has been little change to data on social issues. With more advanced modeling and third-party verification, data tends to become more accurate. As an asset manager, we encourage disclosures to gain a better understanding of the risks. While some managers use ESG scores alone to grade their exposure to risks, we believe this is ineffective. Blind rankings can have numerous underlying risks lurking in their scores. A single underlying risk can represent a disproportionate impact to the value of a franchise and can easily be missed when blended into an average. As active investors, we believe stewardship requires close involvement with company management teams, watching the data for what they do well, issues at risk of being missed, and the real-world solutions they are implementing.

The outlook for quality is positive

The correction in valuations provides a promising backdrop for managers focused on quality and growth. Some investors are moving away from the growth space, creating more realistic sentiment and opportunities for disciplined growth investors to find better entry points. An irrational era characterized by excess liquidity is coming to an end, the last leg of which should occur in 2023. We believe our portfolios will achieve moderate earnings growth next year compared to negative earnings growth for the benchmarks, which will be key for us to create alpha.

Equity markets will continue to benefit from innovation, as companies develop new ways to improve people’s lives and create wealth. Finding companies with sustainable, predictable earnings growth at reasonable valuations will become increasingly important. And without the benefit of easy liquidity, active stock picking will come back into focus.

1. On premise retailing of food and beverages, e.g. in bars, hotels, restaurants