Sydney Wealth Management | The information in this article is current as at 1 October 2022.
The MSCI World (excluding Australia) Net Total Return Index (AUD) returned 0.3% over the past three months and -9.8% over the year to 30 September 2022.
MSCI World excluding Australia Net Total Return Index (Sep-21 to Sep-22)
Source: MSCI, Bloomberg
The outlook for international equities has become more clouded in recent months.
On the positive side of the ledger, valuations are more favourable, particularly outside the US, with major markets trading at discounts of over 10% to their long-term average price-earnings multiple. Normally these circumstances are attractive moments to enter the market as you avoid the headwind of overpaying for equities. If we look at the table below it might suggest an opportune entry point with the US market (the S&P 500) appearing attractive over the medium-term assuming prices revert to long-term valuation averages.
However, there are several counterarguments that give us pause.
First, central banks have shown surprising commitment to combat inflation relative to past hiking cycles. This suggests that rate hikes can continue over the near term until we start to see meaningful drops in the annual inflation rate. When interest rates are rising, this raises the relative value of holding cash versus other assets. It typically triggers a price correction as investors sell out of riskier assets in favour of safer options. We do not have a good gauge on what inflation rate the Feds will consider as “a job done” point to halt hikes. Given that backdrop we think there is meaningful risk of further price falls in the near term.
Second, our outlook for slowing economic growth is not adequately reflected in earnings forecasts. The US is still predicted to grow profits in the high single digits over the next three years. This is hard to reconcile with an expected decline in economic growth which typically sees profits fall. The bulk of equity price declines to date has been driven by multiple contraction, i.e. the S&P 500 in the US now trades at 15.8 times forward earnings, down from 21.4 times at the start of the year, with the 15-year average being 15.8 times. If earnings disappoint, as would seem likely over coming quarters, then the risk of further share price falls in the short term is high.
Lastly the geopolitical environment has been incredibly testing this past year. Uncertainty abounds with the ongoing conflict in Ukraine, volatility in energy prices, tensions with China and impacts of global warming, among others. Government policy too has become another source of uncertainty with the British pound declining over 12% in the quarter to date as investors reacted violently to large deficit-spending budget announcement by the new Truss government. We believe the balance of geopolitical risks in this case could also contribute to weaker equity performance until the policy and political environment stabilises.
On balance we believe the case for being underweight global equities has strengthened over the past quarter with meaningful risk of downgrades to future earnings growth and further derating on the back of rising interest rates. This has seen us move from neutral to underweight global equities.
In the United States, operating earnings for S&P 500 companies are currently expected to rise by 9.5% in 2022, 8.8% in 2023 and 8.6% in 2024. Assuming conventional long-term multiples, we estimate that the United States sharemarket (as measured by the S&P500) is overvalued by 2.2% in the near-term and undervalued by over 15% in the medium-term.
|2022 calendar year forecast||EPS earnings estimates (US$)||S&P 500 fair value estimate||Upside/(downside) S&P 500 = X|
|If 10% below||201.0||3215.7||-12.0%|
|If 10% above||245.6||3930.3||+7.5%|
|2023 calendar year forecast||EPS earnings estimates (US$)||S&P 500 fair value estimate||Upside/(downside) S&P 500 = X|
|If 10% below||218.7||3498.9||-4.3%|
|If 10% above||267.3||4276.4||+17.0%|
|2024 calendar year forecast||EPS earnings estimates (US$)||S&P 500 fair value estimate||Upside/(downside) S&P 500 = X|
|If 10% below||237.3||3796.7||+3.9%|
|If 10% above||290.0||4640.4||+27.0%|
Source: Bloomberg consensus estimates for 2022, 2023 and 2024 as of 27 September 2022.
Over the quarter we saw a derating with expected earnings growth declining for most sectors outside of energy (one of the few to see upgrades on the back of higher oil and gas prices). A rising US dollar contributed to this backdrop, with many businesses flagging the downside risk this posed to their profit guidance due to making international sales worth less in US dollar terms. More cyclical markets have borne the brunt of this move with the MSCI All Country ex-US (an index including developed and emerging market economies besides the US) continuing to de-rate and trade closer to the lows experienced during the global financial crisis.
12-month Forward Price-Earnings Ratios for major markets (Sep-02 to Sep-22)
Consistent with the above, forward Price-to-Earnings (P/E) multiples for markets around the world are now well below longer-term averages as follows:
|Region||Forward PE||15-year Average Forward PE||Potential upside/downside|
|All Country World (ex-US)||10.6x||13.0x||+22.2%|
Recommendation: Move from neutral to underweight.
Valuation multiples (including price to earnings and price to book) fell further in recent months with most major share markets are now trading below their long-term averages. Our concerns however over falling profits given a slowing global economy and rising interest rates suggest there is scope for equities to move another leg down from current levels. Signs of stabilisation on the macro front or further price falls are needed before we can build confidence. Accordingly, we downgrade our recommendation from neutral to underweight.