The End of Irrationality: A Healthy Narrative Will Drive Global Markets Into 2023

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 2007-08 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 have signaled that the economy is stronger than investors expected, and consensus expectations are for 7% EPS growth in the next 12 months. Considering that the median earnings decline during recessions over 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 U.S. interest rate hikes have already occurred, stock performance should be more closely tied to earnings, marking a healthy dynamic. Still, there are opportunities in stocks that have been de-rated. Meaningful dispersion in earnings trajectories across sectors, industries, and companies will require a disciplined approach in the year ahead.

Key Drivers and Opportunities Ahead

Healthy U.S. Consumer

Consumer spending has boosted the 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. Unemployment will be a key factor in determining consumers’ economic health. In past recessions, unemployment has generally not increased more than two percentage points. Even if unemployment rises from September’s 3.5% to around 5%, it would still be relatively low and considered healthy. Further, U.S. consumers’ largest monthly expense is their mortgage, and many have locked in favorable 30-year fixed rates.

While all eyes seem fixated on the housing market, we think the job market is the real key to economic stability. As nominal wages rise, consumers should have increased spending power, although their buying patterns may gravitate towards more durable products and services, such as those in the consumer staples sector.

Potential Beneficiaries of Sell-off

The market sell-off has increased the attractiveness of blue-chip names. More rigor around cost-cutting at Alphabet and Amazon, combined with their growth potential, could make these businesses even more prodigious free-cash flow generators. In contrast, semiconductors are likely to be challenged as growth in the U.S. and Europe slows. In businesses tied to PCs and smartphones, multiples have contracted but earnings still have room to fall.

A clear bifurcation exists in the EM internet space. Profitless players (like Sea, Southeast Asia’s largest internet company) have witnessed concerns around their business models. Despite stock prices falling 70%-80%, companies without sustainable business models are still trading at high valuations, and we expect they will continue to struggle.

In 2023, it will be critical to focus on tech companies that are strategically improving their margins and outlooks for profitability. Profitable players, such as China’s JD.com, that have taken steps to manage loss-making divisions and improve operating efficiency should continue to perform well. Meanwhile, Korean internet business Naver, which has been much slower to do so, is struggling with capital allocation issues as a result of its acquisition of Poshmark.

COVID Recovery Helps Boost Productivity and Healthcare

Growth is returning to pre-COVID levels with the resumption of travel and on-the-premises consumption of food and beverages. Productivity that surged at the pandemic’s start, with the accelerated adoption of new technologies and digitization, has been negative in recent quarters. Nevertheless, as in-person activities and business functions normalize, we expect to see productivity gains.

In healthcare, an end to COVID disruptions will be positive for certain stocks. Postponed medical procedures and preventive care should continue to come to the fore, as will a focus on basic healthcare and catering to an aging population. Quality healthcare companies with structural growth drivers should perform well, particularly those with products or services that are in increasing demand.

Europe’s Energy Challenges and Low-Carbon Transition

Europe’s structural problems – an over-regulated economy and declining population – have been exacerbated by three simultaneous energy challenges: 1) securing alternative energy sources (to Russia), and 2) limiting the price impact on consumers, while 3) achieving emissions ambitions. In 2021, Russia accounted for about 40% of EU gas imports and about 25% of its oil. That reliance is not evenly spread, with Germany and Poland consuming more Russian gas than 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 at an accelerated pace. Europe accounts for just 7% of global greenhouse gas emissions compared to 14% for the U.S. and 31% for China, so initiatives to lower its footprint are limited on a global scale. Europe also faces further pressure of supporting fewer 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 are avoiding businesses linked to domestic European economies, such as local retailers, banks, and cyclical, capital-intensive business in the energy or materials sectors. Instead, we are focused on global franchises that are domiciled in Europe, such as top global luxury brand Hermès, or Nestlé, the largest global food and beverage brand. With costs in local currency but a large exposure to the U.S. 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.

Globally, 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 real-world solutions they are implementing.

Global Outlook for Quality Growth Appears Positive

The correction in equity valuations provides a promising backdrop for disciplined investment managers focused on quality and growth, creating opportunities to find better market entry points. An irrational era characterized by excess liquidity is coming to an end, the last leg of which should occur in 2023. We expect equity markets will continue to benefit from innovation, as companies develop new ways to improve people’s lives and create wealth.

Finding companies with predictable and sustainable earnings growth at reasonable valuations will become increasingly important — and without the benefit of easy liquidity, active stock picking will come back into focus. We believe our global/international portfolios are positioned to achieve moderate earnings growth next year compared to negative earnings growth for their respective benchmarks. That will be key for us to create alpha.