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Equity outlook – Battling the headwinds

Daniel Morris
By DANIEL MORRIS 20.10.2022

In this article:

    The path ahead for global equities is clear; it’s the timing that is uncertain. Inflation has remained sticky and well above central banks’ targets in the US and Europe. Central banks are determined to return it to target, which will likely require a recession. In Europe, recession looks inevitable, simply due to the energy shock.  

    Predictably, equities have fallen this year. We anticipate further declines as recession draws nearer. Talk of a soft landing is now as dated as that of ‘transitory’ inflation.

    The declines in the US have, so far, been driven by the increase in policy rate expectations and the subsequent impact on market multiples (‘the first shoe’), rather than forecasts of lower earnings (‘the second shoe’).

    In fact, analyst earnings estimates (excluding commodities) have dropped by just 2% in the US since the spring and, surprisingly, have risen in Europe, boosted by depreciating currencies and rising estimates for financials alongside higher policy rates (see Exhibit 1).

    The greater rise in earnings expectations for European corporates, in contrast to those in the US, is striking. Both regions are facing higher interest rates, but European equities are less sensitive to higher interest rates due to the greater value orientation of the market and the non-tech composition of its growth sector.

    Europe, however, has the additional burden of extremely high energy prices. Nonetheless, earnings estimates have risen for most every sector, while in the US, they have been broadly declining, particularly for growth sectors such as information technology, internet retail and media & entertainment (see Exhibit 2).

    Irrational exuberance?

    Earnings growth expectations have been resilient in the face of numerous headwinds. Next year, earnings are still forecast to rise by 10.4% (ex-energy) in the US (Q4) and by 7.0% in Europe (full year). These figures could almost be viewed as Pollyanna-ish given the macroeconomic outlook.

    Equity analysts evidently have not received the recession memo. We would agree that the estimates are too high. The slowdown in growth, lower demand – especially in Europe – and higher unemployment rates that will be necessary to bring inflation back to target mean that earnings estimates will at some point have to fall (and prices along with them).

    The evident optimism of analysts stands in stark contrast to the pessimism of most investors and business people: A recent survey showed 91% of CEOs expecting a recession; the bulls-to-bears ratio is near all-time lows.

    Pairing expectations for continued earnings growth with forecasts of recession is however, not necessarily cognitive dissonance. Growth forecasts are positively biased. Since 1987, the average one-year growth forecast has been 13.8%. There have only been three months over the entire period when the forecast was actually negative (notably, one of those months was February 2009, just before the market rebound).

    Forecasts today, while positive, are nonetheless low relative to history, so the pessimism towards equities is in fact broad-based.

    The broad outline of the path for the economy and markets looks clear: Rising policy rates until inflation slows, and then a pivot by central banks to cut rates to support growth.

    The timing is far less clear. After the latest Federal Open Market Committee (FOMC) meeting, forecasts for the US fed funds rate — by both the market and the Fed itself — have at least reached an appropriately high level (see Exhibit 3). We have long felt policy rates needed to rise beyond 4% if the Fed was to achieve its objectives.

    This increase has removed one of the key threats to the market. As policy rates have ratcheted higher, real rates have surged and equity valuations have fallen. At least this particular dynamic should no longer continue to drive markets down.

    There still remains the gap between when the market expects a pivot to occur and when the Fed says it will. Markets are forecasting it in six to nine months, whereas the Fed’s ‘dot plot’ does not foresee it until 2024. This mismatch may be less of a risk, however.

    There are two scenarios where the market’s view turns out to be the right one: The Fed is forced to 

    • Cut rates because inflation has begun to decelerate more quickly than expected (good)
    • Cut rates because growth has slowed more than expected (bad). 

    In either case, equities are likely to react positively to the Fed lowering rates.

    If, on the other hand, the Fed is able to stick to its plan, it would essentially be status quo and this should not require an adjustment in equity prices.

    With fed funds estimates now at what we believe are appropriate levels, real rates may have topped out. The increase in yields over the last year has been dramatic, from a low of -1.8% for five-year yields to 1.8% today. Current levels are now near or above the highs since the global financial crisis.

    Yields are nonetheless still below longer-run averages and one could argue they need to rise by 100bp to have truly normalised. This may yet happen, although lower economic growth would argue for lower real yields than in the past.

    In any event, any additional normalisation is likely to be a far slower (multi-year) process as central banks only slowly unwind quantitative easing and run down their balance sheets.

    This scenario suggests that the underperformance of growth stocks may be ending. Most of the underperformance this year has been driven by rising discount rates and falling multiples, although the return to pre-pandemic patterns of consumption has also had an impact on some of the big lockdown winners such as Amazon.

    If rates tread water from here, the relative earnings growth advantage that the growth style has over value should start to tell (consensus estimates are for 11% YoY EPS gains in 2023 for growth vs. 7% for value).

    While equities broadly are not yet cheap, the fall in growth stock prices has left the z-score of the relative multiple of the Russel 1000 Growth index vs. the Value index at -0.6. Once the pivot in policy rates occurs, the outperformance of growth should accelerate as discount rates fall and value stocks are hindered by lower energy prices and nominal interest rates.

    Earnings tea leaves

    This earnings season will be sifted for clues to the outlook. Given recession forecasts, investors are wondering whether profit warnings will multiply. The recent announcement by FedEx appeared to confirm that sentiment. In fact, recent guidance has not been particularly negative, although companies do seem to be becoming more cautious.

    We are more optimistic on the prospects for the current earnings season. The return to pre-pandemic consumption patterns has tripped up not only internet commerce companies, but also companies whose business, like FedEx, is linked to them. Retailers that have stocked the wrong types of goods and not stocked the right types are also stumbling.

    These missteps impact earnings, but do not signal accelerating weakness in demand. In fact, most of the anecdotes we hear from companies are positive, with demand robust even as companies struggle to meet it.

    Moreover, we have already seen a significant lowering of earnings expectations for the third quarter. The MSCI USA index is expected to post just a 1.5% gain in Q3, and 75% of that is from the energy sector. Excluding commodities, EPS is actually expected to drop by 6% year-on-year.

    With such low expectations, we would not be surprised to see results still beat forecasts. The reaction of equity markets will depend much more on the outlooks companies provide, but with demand still quite robust, we do not expect companies to significantly lower their guidance until the slowdown in demand is much more apparent.

    China and emerging markets

    The underperformance of emerging markets (EM) this year has been almost entirely driven by China (which accounts for 30% of the market index capitalisation). The MSCI EM index had declined by 28% up to 17 October 2022 (total return in USD), while the MSCI World index is down by a bit less (23%).

    Chinese equities, however, have dropped by 34%, while the rest of emerging markets has declined by 25%, that is, roughly the same as MSCI World. EM ex-China equities have even been gaining ground over the last couple of months.

    This comparative resilience is all the more surprising when one considers the strength of the US dollar and the increase in US interest rates, two factors which normally drive more significant underperformance of emerging market equities. Foreign fund flows have been negative as investors opt for the comparative safety of US assets at a much higher return than was available before.

    Macroeconomic factors have been driving the performance of emerging market equities even more than is typically the case. The correlation between equity market returns and USD sovereign debt returns has been notable this year. The government bond returns reflect the need for central banks to raise their own policy rates to match the Fed’s moves, pushing up bond yields.

    Although most countries do not face the same inflationary pressures as the US, increasing food prices weigh more heavily due to the greater weight food has in EM inflation indices. Currency weakness is a function of current account deficits, with energy importers particularly at risk.

    With the outlook both for Europe and the US more negative than positive, emerging markets ex-China have the potential to outperform from here. The adjustment to the rise in both the dollar and Treasury yields has largely taken place and we do not expect further large gains in either in the future.

    While slower growth is a concern for the whole world, emerging markets ex-China do not face the direct impact of the conflict in Ukraine (eastern Europe excepted), nor will central banks need to raise rates by as much as the Fed given that inflation is not as high or as entrenched.

    If commodity prices fall in 2023, those countries that have held up better may lag and vice versa, but in aggregate, we see higher earnings growth for emerging markets. Valuations are also in EM’s favour (particularly for Chinese technology stocks), although that is rarely a catalyst.

    As in the US and Europe, China has unique factors affecting its outlook, namely the zero-Covid policy and a shaky property market. Neither is likely to improve in the near term. Nonetheless, the country will eventually develop and roll out an effective vaccine, and history has shown us that economies rebound quickly once restrictions are eased.

    The property market will take longer to sort out, and the long-existing government objective of reorienting growth away from a dependency on investment to domestic consumption has only become more urgent.

    But there is a critical difference between China and the West when it comes to China’s ability to address these problems: Inflation is low in China (core consumer price inflation is rising by just 0.6% per year), meaning the government and central bank can use both fiscal and monetary policy stimulus to revive economic growth.


    Equity markets still face challenging months ahead. Despite significant increases in US interest rates, economic growth remains far too strong for the Fed to achieve its goal of bringing inflation back to target and recession will likely be necessary. The only question is how deep it will be. Europe is already facing recession and substantial uncertainty in the winter ahead. Although the European equity market appears inexpensive, earnings remain significantly at risk.

    Relative havens are likely to be growth stocks, particularly once the Fed gets closer to ‘pivoting’ away from higher rates to lower ones. Emerging markets ex-China appear comparatively well placed by virtue of being further removed from an overheated US economy and the conflict in Ukraine. The Chinese market boasts attractive valuations and a positive medium-term outlook, but patience will probably be required before the re-rating occurs.


    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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