2022 has been a challenging year for investors. With multiple forces interacting simultaneously – from high inflation and war in Ukraine to volatile energy prices and sharp market swings – uncertainty has reached its highest point since the global financial crisis. Unlikely events, such as the collapse of UK government bonds, have further complicated the picture. But one thing is clear: the lifting wave that lifted all boats is gone.
Without a tailwind of easy money, the next decade will be different from the last. Aggressive central bank tightening this year and fears of a recession have caused stocks to fall, although recent earnings reports have shown that the economy is stronger than investors expected and the consensus forecast suggests earnings per share growth of 7% over the next 12 months. Given that average earnings declines during recessions over the past 30 years have been in the low to mid-tens, we believe today’s consensus forecasts are optimistic.
Given expectations that most US rate hikes have already occurred, future equity performance should be more closely linked to earnings, which is a healthy dynamic. Nevertheless, there are opportunities in stocks that have been downgraded. Significant variation in earnings trajectories across sectors, industries and companies in the coming year will require a disciplined approach.
The US consumer remains healthy
American consumers have boosted the global economy in recent years, aided by fiscal stimulus and accommodative monetary policy. Recent headlines about low personal savings rates and record levels of consumer debt may cause alarm. Consumer spending has slowed, but the unemployment rate will be a key factor in determining the economic health of the American consumer. In previous recessions, even deep ones, the maximum increase in the unemployment rate usually did not exceed 2 percentage points. With this in mind, if the US unemployment rate rises from a low of 3.5% to around 5%, it would be relatively low and quite a healthy scenario in a historical context. In addition, the biggest monthly expense for US consumers is mortgages and many have locked in favourable 30-year fixed rates. Thus, as nominal wages rise, consumers should indeed have more spending, although their preferences may be skewed towards durable goods and services. Although all eyes are on the US housing market, we believe that the labour market is key to economic stability in the US.
Opportunities in the tech sell-off
Despite continued pressure on the economy next year, the sell-off has increased the appeal of blue-chip names. A tighter spending approach at Alphabet and Amazon, combined with their growth potential, could make them even more impressive free cash flow generators. By contrast, semiconductors are likely to struggle due to slowing growth in the US and Europe. In the PC and smartphone businesses, multiples have declined, but profits still have room to fall.
There is a clear bifurcation in the emerging markets internet space. Profitless players such as Sea, Southeast Asia’s largest internet company, whose business includes Garena and Shopee, have witnessed concerns about their business models. Despite share price declines of 70%-80%, companies without sustainable business models are still trading at high valuations and we expect them to continue to struggle. Profitable players, such as China’s JD.com, should continue to perform well after taking measures to manage loss-making divisions and improve operational efficiency. Meanwhile, Korean internet business Naver is doing much slower and is struggling with capital allocation as a result of its acquisition of Poshmark. Next year, it will be more important to focus on companies that strategically improve margins and profitability prospects.
COVID recovery boosts productivity and health care
Growth is returning to pre-QEAD levels, thanks to a resurgence in travel and a return to trade consumption1. Productivity rose sharply at the start of the pandemic thanks to the accelerated adoption of new technology, new ways of working and digitisation, but has been negative in recent quarters. Nevertheless, when face-to-face and business functions normalise, we expect productivity to rise.
The end of COVID outages will also have a positive impact on some healthcare stocks. Deferred procedures and preventive care should come back to the forefront, as should a focus on basic health care and services for the ageing population. Quality healthcare companies with structural growth drivers should perform well, especially those whose products or services are in growing demand. In addition, it may be underestimated that, as a result of COVID, some long-term health trends may now be even worse than before.
Europe contends with energy challenges as shift to low carbon accelerates
Europe’s structural problems – an over-regulated economy and a shrinking population – are exacerbated by energy uncertainty. Europe faces three simultaneous energy challenges: 1) securing alternative energy sources, 2) limiting the impact of prices on consumers and 3) simultaneously meeting emissions obligations. In 2021 Russia accounted for around 40 per cent of EU gas imports and around 25 per cent of oil imports. However, this dependence is unevenly distributed, with higher consumption of Russian gas in Germany and Poland than in France. The continent is also at risk of further security breaches and other supply disruptions that could once again lead to a supply crisis.
Despite a temporary switch to dirtier fuels such as coal or lignite, the Repower EU plan aims to phase out Russian fossil fuels and accelerate the energy transition. However, when it comes to greenhouse gas emissions, Europe is ahead of its time, currently accounting for only about 7% of global greenhouse gas emissions, compared to 14% for the US and 31% for China, so initiatives to reduce domestic impacts are limited on a global scale. On climate change, the challenge for Europe is to support less affluent countries in building low-emissions economies and to strengthen protection against the physical impacts of long-term changes in temperatures and weather patterns.
Given the weak outlook, we are avoiding businesses linked to the domestic European economy, such as local retail chains, banks and cyclical, capital-intensive businesses in the energy or raw materials sectors. Instead, we focus on global franchises based in Europe, such as Hermes, the world’s leading luxury brand, or Nestle, the world’s largest consumer food and beverage brand. Multinational companies whose costs are denominated in local currencies, but which are heavily exposed to the US economy, could benefit from a stronger dollar. Although currency volatility will persist, the long-term strength of the dollar is unlikely to diminish given the resilience of the US economy and its independence in food and energy.
Emerging markets: India and Indonesia poised for continued growth, Brazil moving in the right direction
Rising US interest rates and a stronger dollar tend to have a negative impact on emerging markets. Despite higher economic growth, emerging markets have again failed to outperform developed markets this year. If you look under the bonnet, you can see a bifurcation in the emerging markets’ performance. Even with currency depreciation, key emerging markets – Indonesia returned 6%, India was down just 5% and Brazil was up 11% – all in dollar terms. However, China is down 31% and the exit of Russia, which makes up around 5% of the MSCI EM index, has affected returns. If China and Russia were excluded, emerging markets would have vastly outperformed the US.
In India and Indonesia fiscal stimulus has been more moderate than in developed markets, central banks have pursued cautious monetary policy and countries have kept inflation under control. Consumers have insufficient leverage and credit growth is improving. Income growth in India’s urban markets is outpacing inflation and the IT sector is performing well. Importantly, currencies in both countries are holding up better than expected, despite a sharp rise in US interest rates and a stronger dollar. As US interest rate expectations peak, these currencies could beat expectations over the next 18 months.
Indian structural reforms, such as the introduction of the goods and services tax, improvements in bankruptcy law and the clean-up of weak financial institutions, have been important, but also hindering factors in growth over the past five years. Thanks to these reforms and the strengthening of the banking system, India’s GDP growth over the next 12 months is forecast at 6-7% and non-performing loans at banks have fallen significantly. Indonesia is also investing in infrastructure, forcing commodity producers to invest in downstream value-added production and benefiting from offshoring from China, which is helping Southeast Asia as a whole. We expect these growth drivers in India and Indonesia to continue in the medium term.
Rising commodity prices have been a tailwind for Brazil, helping boost GDP growth forecasts to 2.5-3% this year. The election of left-wing Luiz Inácio Lula da Silva as president passed peacefully. Concerns shift to fiscal policy and the possibility of increasing social transfers. However, Brazil’s congress has moved further to the right, meaning that any plans are likely to be softened. Political headlines change daily and Brazil remains a volatile market, but ultimately it is heading in the right direction.
Beneficiaries of changes in the supply chain
Some investors underestimate China’s manufacturing position – replicating it in other countries will be difficult and time-consuming. Shifts in the supply chain are happening, but they will be gradual. Vietnam is well positioned to be a long-term beneficiary, thanks to its young and highly educated workforce and an economy prepared for semiconductor and apparel manufacturing. Indonesia and Malaysia are benefiting more gradually. India is boosting domestic production through the Product Linked Incentive (PLI) scheme, which offers incentives while increasing sales of goods made in India.
Large technology companies looking for semiconductor suppliers are targeting manufacturers with strong competitive advantages, high levels of efficiency and the ability to produce cutting-edge technology, favouring Taiwan and China. But industries that rely more heavily on labour demographics and cheaper labour, in Indonesia, Vietnam and Mexico, could benefit from moving supply chains offshore.
Property sector and COVID, the two biggest drags on China this year
The crackdown on borrowing among property developers has exacerbated China’s real estate crisis. With a significant number of projects not completed, the problem is somewhat more serious than reports suggest, and there are still concerns about leverage in the economy as a whole. Given the relatively modest government stimulus, it will take a long time for the real estate market to stabilise, even after the changes announced at the recent Communist Party of China (CPC) Congress. We remain cautious about a recovery in the real estate and banking sectors and the underlying materials associated with these sectors.
China’s “zero rate policy”, which has been firmly implemented this year, is set to continue in the short term. However, the government has announced 20 measures to ease restrictions on COVID, including reduced quarantine time for close contacts and those arriving from abroad, a shift towards containment and increased vaccination efforts. This has raised expectations that the government will move towards reopening in 2023. We are more positive about the companies that will benefit from reopening and believe that the market will look through the lens of future short-term lock-ins.
Significant margin improvements at companies such as Yum China and JD.com, even in the face of ongoing blockchains, have been underestimated by markets. Yum China reported a margin improvement of 400bps, almost back to pre COVID levels, while JD.com reported a margin improvement of 200bps, doubling profit and beating consensus estimates by 40% in the latest Q3. Any top line improvement could reinforce earnings recovery in 2023.
China drives zero carbon emissions
China, often referred to as the “workshop of the world”, has become the world’s largest carbon emitter, given its manufacturing exports combined with its own consumption. The country has a natural incentive to improve performance because many of its coastal cities, where much of the manufacturing and population is concentrated, are at increased risk of flooding from climate change. The government aims to cut carbon emissions as much as possible by 2030 and reach net zero by 2060 – a decade later than the 2050 greenhouse gas (atmospheric) budget estimated by the IPCC if global warming is capped at 1.5°C.
China is on its way to electrification with the massive introduction of wind, solar and nuclear power. Replacing old coal-fired power plants with new, more efficient ones would also improve the carbon footprint. Other initiatives include carbon trading and the development of carbon capture and storage. The costs will be high and the targets will be challenging, but we believe China is motivated to meet its targets – the problem is time rather than inclination.
Businesses are paying more attention to the transition to zero
Not only are countries aiming for zero, but many companies are aiming to become carbon-neutral. Investors will need to assess the aggressiveness and achievability of their deadlines. Consequently, the amount and quality of data on environmental issues is improving in Europe but the data on social issues is largely unchanged. With better modelling and third-party verification, the data is becoming more accurate. As an asset manager, we encourage disclosure to better understand risks. Although some asset managers use ESG scores alone to assess risk exposure, we believe this is ineffective. Blind ratings can have many hidden risks lurking in the scores. One underlying risk can have a disproportionate impact on the value of a franchise and can easily be missed when mixed with the average. As active investors, we believe that governance requires close engagement with the companies’ management teams, tracking data on what they are doing well, the issues at risk of being missed and the real solutions they are implementing.
The quality outlook is positive
A correction in valuations provides a promising backdrop for quality- and growth-oriented managers. Some investors are withdrawing from growth, creating more realistic sentiment and opportunities for disciplined growth investors to find better entry points. An irrational era characterised by excess liquidity is coming to an end, with the last leg due in 2023. We believe our portfolios will achieve moderate earnings growth next year compared to negative earnings growth for benchmarks, which will be key for us to build alpha.
Equity markets will continue to benefit from innovation as companies develop new ways to improve people’s lives and create wealth. Finding companies with sustainable, predictable earnings growth at reasonable valuations will become increasingly important. And without the advantage of easy liquidity, active stock picking will become relevant again.
