by Gabriel Sauma, Russell Investments
- Q1 2023 was a more favorable environment for Global ex-U.S., Emerging Markets, Europe, U.S. small cap, UK, Australia, Canada and Global Real Estate managers
- The quality factor was the standout performer across most regions in Q1, with the growth factor also outperforming
- Managers anticipate that markets will remain volatile until there is more concrete evidence around the fall in inflation and interest-rate stabilization
After a first quarter dominated by volatility and reversals, are equity mangers anticipating more ups and downs in the months ahead?
The answer, according to our latest equity market outlook: Yes.
While immediate concerns on potential systemic risks to the economy stemming from March’s banking crisis have abated, banks remain a watchpoint for investors. Managers are also closely scrutinizing inflation, which appears to be moderating. Overall, they expect market volatility to continue until there is more concrete evidence around the decline in inflation and, subsequently, interest-rate stabilization. Managers also generally still expect earnings to come under pressure in the near-term on the back of rising input costs and waning demand.
Despite the volatility in the first three months of the year, the first quarter was another positive one, with all equity markets delivering positive absolute returns. This was particularly the case in U.S. dollars (USD), given the greenback’s weakness against most developed market currencies. USD weakness is expected to continue, particularly as the U.S. Federal Reserve (Fed) approaches the end of its rate-hiking cycle. This weakness should continue to be supportive for non-U.S. assets.
On balance, the first quarter proved to be a more favorable environment for active managers in Global ex-U.S., Emerging Markets, Europe, U.S. small cap, UK, Australia, Canada and global real estate while being more challenging for U.S. large cap, Global, Japan, long/short and infrastructure managers.
The quality factor was the standout performer across most regions, with the growth factor also outperforming. Conversely, momentum, low volatility and value lagged with varying degrees. Value performed better in emerging markets, the UK and Japan. In emerging markets, growth underperformed.
As a result of the reversal during this period, information technology was the best-performing sector, with communications services and consumer discretionary also exhibiting strong returns. Energy and financials were the worst-performing sectors, due to the twin headwinds of falling energy prices and recessionary fears triggered by the banking crisis. Weakness was also observed in the healthcare, utilities, real estate and consumer staples sectors.
Drawing on our unique relationship with underlying managers, we’ve compiled these and other insights from specialists across the manager universe into an easy-to-read report. Listed below are the chief tactical observations from key equity and geographic regions around the globe during the first quarter of 2023.
Sit and wait
- Turnover of Australian cash equities was 26% lower in Q1 23 relative to Q1 22.1 While Q1 22’s turnover was elevated by the Ukraine invasion, decreased turnover is consistent with our observations of little change in portfolios.
- Managers spent the latter part of 2022 increasing the defensiveness of their portfolios, selectively adding to healthcare, gold and insurance names and seeking quality companies overall.
- Within consumer discretionary, managers prefer gaming and education companies, which are more resilient in a downturn than retail and travel. This is consistent with the median manager being above benchmark in the quarter after the February ‘23 reporting season, where there were more misses than upside surprises to expected earnings.
- Managers are expecting that earnings guidance will be revised down in the May confession season, prior to the August ‘23 reporting season. As such, there is a preference for retaining existing positions and only trimming or adding when valuation opportunities arise.
NIMs, not SVB, impact Aussie banks positioning
- Increased competition impacting future net interest margins (NIMs) and expectations of slowing credit growth have impacted views on banks more than Silicon Valley Bank (SVB)-related concerns.
- Most managers are maintaining their underweight to the sector.
M&A activity heats up
- The first quarter saw an increase in takeover offers for ASX companies, predominantly from offshore companies.
- Managers note the potential for takeovers provides a floor for value companies.
Managers anticipating economic slowdown
- Managers expect the monetary tightening by both the Bank of Canada and the Fed to cause a recession in both Canada and the U.S. later in 2023.
- Based on the expectation of economic weakness across North America, investors are shifting positioning to emphasize companies with more stable revenue prospects or higher quality, more durable business models within cyclical industries.
Bank industry concerns
- While the Canadian banking industry is much better positioned to weather banking crises than its U.S. counterpart, managers expect a tighter lending environment in Canadian banks as a spillover effect from the Silicon Valley Bank crisis. More conservative lending will pressure banks’ earnings prospects and also exacerbate economic weakness.
Enthusiasm for M&A
- Managers are optimistic about the environment for companies seeking to grow through acquisition. Relatively low valuation multiples across the market create a target-rich environment for strategic buyers, with investors favoring those with a track record of accretive acquisitions.
Copper and lumber are favored segments within materials
- Despite weakening economic sentiment, investors do not expect a severe recession and they are optimistic about copper and lumber when the economy inflects upward. While several commodity industries have tight supply, both copper and lumber have very favorable secular demand prospects.
- Increased demand for copper will be driven by greater electrification and alternative energy, while lumber demand will be driven by housing shortfalls across North America.
Emerging markets equities
China remains an opportunity despite sentiment swings
- Managers are adding selectively to China amid increasing earnings volatility and aggressive market action. This has led to profit-taking among internet names that rerated strongly.
- Hospitality, travel and leisure remain key areas of focus as part of China’s reopening story.
Oversold Latin America sentiment opens selective opportunities
- Higher-quality Brazilian financials are seen as attractive, owing to negative sentiment following the political stalemate after President Luiz Inácio Lula da Silva’s election win.
- The recent market selloff is presenting selective valuation opportunities in the energy sector.
- Mexico is seen as a major beneficiary from near-shoring of U.S. companies. Investors are also increasingly optimistic on the travel sector.
Improvements on semiconductor cycle
- While inventory overhang remains a near-term issue, investors are constructive on the semiconductor and memory cycle, given the clear structural demand from digital infrastructure and AI (artificial intelligence).
India is reminded of governance challenges
- With scandals hitting the Adani Group, managers are seeing opportunities in higher quality competitors that are well placed to take market share.
Saudi Arabia reforms to potentially unlock investor returns
- Despite weaker oil prices, managers see earnings green shoots from Saudi Arabia’s growing privatization and national investments. High-quality banks are expected to be the primary beneficiaries.
Investors look to mitigate geopolitical risks
- Given the uncertainties around U.S.-Russia/China relations, managers have increased exposure to non-China manufacturing hubs, such as Vietnam and India.
Europe and UK equities
The time for banks to shine?
- Q1 brought back memories of 2008, but importantly, it served to confirm that banks have meaningfully evolved since the Global Financial Crisis (GFC).
- Higher liquidity ratios, higher capital buffers and more conservative business practices are now commonplace in the industry. This, combined with cheap valuations and industry tailwinds from rising interest rates, make it an attractive area for investors.
Higher interest rates will keep testing the system
- Curing a system addicted to cheap borrowing is no easy task, and it can have extreme consequences for illiquid or highly leveraged businesses. While the average European corporate is well-capitalized compared to 2008, pockets of risk remain in the market.
- The SVB debacle helped highlight that private equity was one of these pockets of risk, but unprofitable growth and real estate could be added to the list. Share prices in these industries have already corrected, but managers expect further downward pressure.
Investors looking beneath the surface in the UK
- UK equities have been garnering increasing attention from global investors based on their attractive valuations. Trading at historically low P/E (price-to-earnings) multiples with an attractive dividend yield, the market is cheap in a developed market context, given it is heavily exposed to global companies with global revenue streams rather than to the UK domestic economy.
- While the UK market has a heavier exposure to value sectors such as energy, materials and financials, these sector biases do not fully explain the valuation discount.
- Having historically been known for its dividend preferences, more UK-listed companies are now turning toward share buybacks to deploy capital at these low valuations, which may provide some underpinning for share prices.
Cautious optimism despite a mixed earnings picture
- While profit margins have fallen, cost pressures have started easing, which will allow nominal growth to continue. Managers are looking for opportunities supported by margin expansion.
- Technology companies have derated and look interesting, since businesses are adjusting capital discipline in response to the tighter interest rate environment.
- Managers are being pragmatic on valuations and have taken profits in some of last year’s winners, such as energy.
Reducing tail risks with more defensive exposure
- Given macroeconomic risks, managers continue to reposition some cyclical exposure into defensives and secular stories, e.g., healthcare.
- Managers are also trimming lower quality names for downside protection. Awareness has increased around profitability, capital allocation and competitive moats.
Market volatility triggers idiosyncratic opportunities
- Market uncertainty and fear sentiment has led to dislocated fundamentals, favoring stock pickers.
- Long duration investors remain committed to innovation areas, given continued earnings strength and relative valuations.
Investors shrug off banking worries
- Managers have little exposure to lower-tier banks where recent failures were linked to riskier deposit bases and poor governance. This is not seen as systemic, given the improved health and robustness of financial regulations post-GFC.
Opportunistically adding to emerging markets
- Managers continue to find valuation plays outside of the U.S., namely emerging markets and Asia.
Managers remain calm despite turmoil in the financial sector
- Managers see banking systems in developed countries as well as corporate balance sheets as relatively strong. They believe they’re able to absorb emerging stresses with little systemic risks.
- Some managers have trimmed financial exposure, expecting negative impact to the economy—including banks’ return expectations. Nonetheless, Japanese banks are generally viewed as being well capitalized.
Different interpretation of Fed’s pivot
- An increasing number of managers expect the inflation rate to come down and the Fed to stop raising rates this year.
- Growth managers believe the market environment will become favorable for growth stocks due to stabilizing or declining rates.
- Value managers, on the other hand, believe that higher-for-longer inflation and/or interest rates—when compared to the pre-COVID-19 period—will dampen multiple expansions.
Expectations for cycle bottoming out
- While concerns remain over continued inflationary pressures, financial instability and a possible U.S. recession, managers expect the economic cycle to bottom out this year. This has led some to increase exposures to early cyclicals, such as tech and/or capital goods.
Japan’s relative earnings looks good
- Reopening beneficiaries continue attracting investors, thanks to the continued normalization of economic activities in East Asia.
- Auto positions have been increased in anticipation of a recovery in production, due to a possible resolution of supply disruptions.
- There is increasing pressure from the Tokyo Stock Exchange to improve the capital efficiency for stocks traded at P/B (price-to-book) below 1x. It may take time, but managers view it positively.
Hedge funds shift to safety as recession concerns increase
- As the risk of a recession increases, managers are rotating out of perceived risky sectors and regions, such as shifting from small to large cap (via tech and healthcare) or from international to U.S. equities.
- Hedge funds have been increasing gross exposure as they see compelling idiosyncratic opportunities—both long and short—but they continue to maintain low net exposure, as they’re highly concerned about the macroeconomic environment.
- Silicon Valley Bank’s demise only adds fuel to the fire, increasing recession concerns as a potential signal of the beginning of a banking and credit crisis.
Tech hedge funds no longer need to sit on dry powder
- For many tech managers, sitting on cash is no longer necessary as tech valuations near their long-term averages and new trends in technology (i.e., AI) are creating ample alpha opportunities.
- Managers cite AI as the biggest tech trend of our lifetime. ChatGPT, one of the multiple AI models, is growing at a faster rate and receiving more demand than any other technology in recent history.
Real assets equities
Banking crisis and economic uncertainties
- Infrastructure and real estate offer defensive attributes, mainly driven by the contractual nature of leases and concessions, which provide stability of cash flows. However, the banking crisis in Q1 highlighted direct and indirect risks to both sectors.
- Managers are expecting elevated inflation to persist. They point to two historical periods —the post-WWII period and the 1970s (the era of “WIN” or Whip Inflation Now)—where high unexpected inflation was initially contained and then experienced a large resurgence.
- The periodic rate cases in regulated utilities allow inflationary costs to be passed on. In concession-based sectors, airports and toll roads, CPI (consumer price index) increases are included in concession agreements. The pass-throughs are not immediate and share prices may be negatively impacted in the short-term, as investors use higher discount rates on the long-dated cash flows.
- North American freight rail is well positioned, having been oversold for several reasons, including a decline in volumes and the derailment/release of hazardous material in Ohio. Freight rails will be required to make improvements to their operations and abandon plans of a single engineer per train. The railroads are vital to the economy and growth, and pricing power will be strong, so a recovery is likely—even with the higher cost structure.
- The banking problems have made it harder to finance new construction and acquire properties with large levels of debt. Transaction volumes globally have fallen to GFC levels, which is negatively impacting valuations in the private markets.
- The listed markets are open for business, and have already priced in substantial levels of risk, so this may be a good entry point for long-term-oriented real estate investors.
U.S. large cap equities
Continued expectations for a recession
- Though U.S. markets rallied in the first quarter, growth and value managers alike continued to reduce their exposure to companies in more cyclical sectors like industrials, consumer discretionary and financials.
- Burned by holdings in crowded, consensus positions in 2022, growth managers are being more selective in their current positioning, favoring more established, profitable companies.
Implications for banks
- The collapses of Silicon Valley Bank and Signature Bank in March were not seen by managers as contagion risks, given the quick actions by the Federal Reserve, Treasury Department and FDIC (Federal Deposit Insurance Corporation).
- There is broad consensus among managers that returns for banks, regardless of size, will decline over time as the result of increased regulatory costs. This view, taken together with the above-noted worries over a recession, is leading managers to reduce their bank and related financial holdings.
- Though opinions are mixed, some managers are seeing value emerge among the larger brokers and are cautiously adding.
- Commercial real estate lending is seen as an emerging, though manageable, risk—particularly for regional banks. However, it will likely take years to play out as leases come up for renewal.
- Broad market index returns were dominated by a handful of mega cap companies within technology, communication services and consumer discretionary, with the 10 largest companies by market cap accounting for nearly 90% of the total market return.
- Though this degree of concentration represented a headwind for active management in the first quarter, historically periods of significant market concentration are often followed by meaningful outperformance for active managers.
U.S. small cap equities
Recession expectations continue to grow
- Managers expect the recent banking panic to drive banks to curtail lending, which would exacerbate the impact of rate hikes and push the U.S. economy closer to a recession.
Cuts in earnings estimates expected to continue
- Given the economic backdrop, managers expect earnings estimate cuts to continue. They believe sell-side estimates are still too optimistic. Most managers are turning defensive, as they believe that despite the relatively attractive valuations, there’s more downside for small caps, which tend to underperform large caps in recessions.
Market-oriented managers find opportunities in GARP stocks
- After gravitating toward deeper value stocks in 2022, managers with flexibility in their process are now finding opportunities in growth-at-a-reasonable-price (GARP) stocks, as they have much better earnings visibility for these stocks. As such, they are expecting the valuation of their portfolios to move slightly higher.
Value managers turn cautious, struggle to find new ideas
- Value managers acknowledge cash levels in portfolios have risen in recent months with a dearth of new ideas. They are specifically turning cautious on industrials, as they expect revenue growth to slow and margins to get hit as inventories remain at high levels while orders continue to be weak. While banks, office REITs (real estate investment trusts) and energy names are screening well on valuations, the fundamentals are less compelling. Beneficiaries of infrastructure spend are a rare exciting area for some value managers.
Secular over cyclical: The new mantra for growth managers
- Growth managers are now rotating out of cyclicals like energy and industrials into long-term secular growers such as healthcare and relatively cheaper technology stocks. This is because they are now more concerned about recession risks and believe these secular growers are likely to perform better in a recession.
The bottom line
Signs of a moderation in inflation and the likelihood that the Fed is nearing the end of its aggressive rate-hiking campaign are welcome news for equity managers. However, until there is more substantial evidence that pricing pressures are easing at a fast-enough pace for central banks to hit pause, managers expect volatility to remain the name of the game. In such an uncertain environment, we believe the views of specialist managers will be critical to identifying and exploiting both risks and opportunities. We look forward to continuing to share these insights with you as the year progresses.
1 Source: Australian Securities and Investment Commission’s Equity Market Data
2 Data and chart from Morgan Stanley Prime Brokerage
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