While the path for global equities is clear, the timing is uncertain. Inflation is still sticky and well above the objectives of central banks which are determined to drive it back down to target. Recession now looks likely, first and foremost in Europe, simply due to the energy shock.
We anticipate further equity declines as recession draws nearer. US stock valuations have fallen due to higher policy rate expectations (‘the first shoe’) rather than forecasts of lower earnings (‘the second shoe’).
A case of irrational exuberance? Equity analysts evidently have not received the recession memo. Their optimism stands in stark contrast to the pessimism of most investors and businesspeople.
As for the next market moves, there is a gap between when the market expects a turnaround by the US Federal Reserve and when the Fed says it will turn.
Real rates may have topped out ahead of slower growth. This scenario suggests that the underperformance of growth stocks may be ending.
We are optimistic on the prospects for earnings. We do not see signals of accelerating weakness in demand, so we would not be surprised to see earnings beat forecasts.
Elsewhere, the underperformance of emerging markets has been almost entirely driven by China. The resilience of EM ex-China is surprising when one considers the strength of the US dollar, the rise in US interest rates and foreign investors opting for US assets offering a much higher return than was previously available.
Given the poor outlook for Europe and the US, EM ex-China has, in our view, the scope to outperform from here. Emerging markets ex-China do not face the direct impact of the war in Ukraine (eastern Europe excepted), nor will central banks need to raise rates by as much as the Fed. In aggregate, we see higher earnings growth for emerging markets.
As for Chinese equities, valuations are attractive and the medium-term outlook is positive, but patience will probably be required before the re-rating occurs.
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