In short: stock markets mark a pause and rotate

Key Points

Cooling off period: it is often the case that the summer months see stock markets marking a pause, even when they have been on a solid march higher, as observed this year.

Momentum is still positive: while US, European, Japanese and emerging stock markets all dipped in August on low volumes, they all remain substantially higher than in October 2022.

In our view, the resilience of corporate earnings underlies strength in developed market stocks, with profit margins and cash flows still robust and long-term debt financing (via corporate bonds) already secured at low rates.

The time to question our current Positive stance on stocks (held since late November 2022) will be if and when global recession clouds become more apparent. Yes, there is some disappointment in eurozone and Chinese economic activity. However, the US, Japan and Latin America continue to show resilient growth. Thus, we believe that we are not at this decision point just yet for global stocks. But this will only remain true if long-term interest rates stabilise or ease lower.

On a regional basis, we maintain our Positive stance on global stocks, favouring the eurozone, UK, Japan and Latin America (this latter has outperformed the US over the last 12 and 24 months – see graph). 

Main recommendations

(+) Health Care is a key quality defensive sector that has consistently outperformed other defensive sectors, and benefits from the ageing population megatrend. We continue to rate Healthcare as Positive.

Stay diversified including in some cheap and solid cyclical stocks (Energy, European Financials).

(+) Country-wise, Japan, Europe and Latin America look more attractive than the US.

Be cautious/selective with expensive market segments, such as Consumer Staples, some large-cap US tech stocks and some Consumer Cyclicals: pricing power is weakening and operating profits are under pressure from rising costs. Some very high P/E ratios are difficult to justify.

(-) The key risks are that the US Federal Reserve or the ECB could raise interest rates more than expected, triggering a sharper economic slowdown or even a recession. Liquidity is likely to fall in the coming months, especially in the US.

A sharp correction in the US housing or commercial real estate market could weigh on consumption, or even result in non-performing loans. 

Equities outlook

Equity Markets pause after a strong start in 2023

The economy has been quite resilient so far in 2023, leading to a general recovery in equity markets. This is particularly the case in the US where the expected recession (if it indeed occurs) will probably not take place before 2024. Economic data have been better than expected there, especially in the Services sector. The forced savings accumulated during the COVID years as well as the strong labour market are supporting wages and consumption. Note that the services economy is now slowing down in many parts of the world (though still strong) whereas the manufacturing economy seems to be bottoming out (see page 5 section 2/ Two speed economy).   

The situation is less rosy in Europe where several economies are on a brink of recession, especially Germany. Europe is still licking the wounds of the energy crisis it suffered in the wake of the war in Ukraine and a willingness of several OPEC+ countries to constraint the supply in order to take oil prices to higher levels.

In the Far East, Chinese economic growth is still subdued, hurt by the real estate crisis. The stimulus measures taken so far have been insufficient to restore confidence in the economy (more on page 8, section 5: Asian Equities View). The depressed Manufacturing sector has also been a major headwind to the global Materials sector recovery and to European exporters. Chinese stocks have therefore been disappointing in 2023 (see chart).

The best market segment so far this year is the US ‘Mega-Tech’ stocks thanks of course to the Artificial Intelligence (AI) hype. They are now richly valued and consolidating. Therefore, we also suggest looking at other segments benefiting from AI, such as the ‘engines' of AI, Semiconductors, and sectors expected to grow significantly in productivity, for example Health Care. This latter has been lagging the rest of the market in H1 but it is now outperforming and ready to break through (cf. page 7/section 4).

Several sectors are lagging, and we would need to see a broadening of sectors and stocks trending upwards to keep the rally going. The Health Care and the Energy sectors are picking up and seem to be in a good position to rally further (cf. page 7/section 4).

Some other sectors have been improving and outperforming over the last few months, such as European Financials, where we keep our preference for solid retail banks in the core eurozone countries because they are still very cheap. European REITs are also improving as we are probably close to peak interest rates/bond yields. Besides, European REITs now seem to be actively tackling their balance sheet problems.

In general, we remain Positive on equity markets with a preference for regions outside the United States (US equities are already fairly valued, especially large caps). 

Asian Equities view

China Economic outlook lacks clarity near term

•The Politburo meeting in late July had reignited hope for immediate measures to revive consumer and business confidence, stronger support for the property market and resolutions to the local government’s debt problems. However, slow progress in easing measures, coupled with Country Garden’s debt woes and recent defaults in trust/wealth management products have dampened the already fragile sentiment further. Recent cuts in PBoC key policy rates proved insufficient to reverse the trend, although we think that systemic risk in the financial system is limited.

•Our base-case scenario is no big-bang stimulus in the near term, but we will continue to see targeted easing measures in a “reactive” rather than “proactive” manner, which is in contrast to what investors yearn. Authorities seem willing to tolerate slower growth to achieve their longer-term goal of “common prosperity”.  However, any further delay in a decisive response to restore confidence and revive domestic demand would risk a fast-deteriorating economy, which may, in turn, require an even more costly and larger fiscal expansion in the future for growth to recover.

•Market expectations remain very low and valuations attractive. Any positive surprise in the actual stimulus measures would be welcome. The key would be if the market were convinced that any stimulus was big enough to trigger a meaningful turnaround in economic momentum. Market volatility will remain high, while we see trading opportunities in selective areas with more favourable policy support, such as EVs, consumer staples and durables, internet, technology and tourism as these sectors are somewhat shielded from the property downturn.

Sector allocation: some sectors that lagged in H1 are now recovering 

As we expected, a sector rotation is occurring, BENEFITING the lagging health care and energy sectors

Recent economic figures have been generally quite disappointing, particularly in China and Europe. However, this weakness was expected and a severe recession has already been priced in. So, take advantage of the low valuations of some cyclical sectors and stocks to accumulate.

- Summer is typically the most difficult period for equities. Among the defensive sectors, we maintain our preference for Health Care. This sector is a long-term outperformer and, among other, fits well with the innovation, ageing population and AI themes.

- Cautious investors may diversify into other strong, and/or cheap and/or high-dividend stocks, such as Energy, European Financials and solid Utilities that benefit from energy transition.

- We would still avoid expensive tech and consumption stocks, after recent outperformances. These sectors are expensive and currently correcting. Besides, the consumer is increasingly reluctant to accept the sharp consumption price rises observed since early 2022. 

Before the Summer, we recommended revisiting sectors having ‘unfairly’ lagged during H1 this year. In particular, apart from Health Care, we recommended the Energy sector as we expected demand to keep recovering, whereas supply would stay constrained

- Energy has been the star performer this Summer, with oil prices recovering from around USD 70/barrel to around USD 90 today. Oil supply will remain constrained by Saudi Arabia and Russia. On the demand side, the travel recovery, the strong economy in many parts of the world and the development of e-commerce are all supporting oil prices.

- On the other hand, the materials sector performance has been subdued due to the weak manufacturing activity outlook, particularly in China. The sector valuations are however very attractive.

- As technology is expensive and facing new issues, remember that there are other vehicles to play AI, including companies in Health Care, Business Services, Industrials, and even some Financials and Utilities that are expected to enjoy productivity gains!

- Listed European Real Estate is recovering but still suffers from uncertainties about its refinancing, growth and dividends.