The MSCI World (excluding Australia) Net Total Return Index (AUD) returned 4.0% over the past three months and -12.5% over the year to 31 December 2022.
MSCI World excluding Australia Net Total Return Index (Dec-21 to Dec-22)
Source: MSCI, Bloomberg
The outlook for international equities remains clouded.
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 such discounts provide attractive opportunities to accumulate equities.
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 may continue over the near term until we start to see even larger declines in the annual inflation rate. US inflation has begun decelerating from a recent peak of 9.1% annual growth in July to 7.1% in November. This is well-above the average growth rate prior to the coronavirus pandemic. If the Fed is to be treated credibly there are still more rate hikes in store with a Fed-projected cash rate of 5.1% to 5.4% for 2023 in the US (versus a current range of 4.25% to 4.5%) before declining in 2024. By contrast current market pricing is only suggesting a peak rate of only 4.85% suggesting growing scepticism by investors.
When interest rates are rising this raises the relative value of holding cash versus other assets. It typically drives prices of risk assets lower as investors divert capital to safer options such as cash. Given that backdrop we think there is meaningful risk of further price falls in the near term.
We also harbour concerns that the outlook for slowing economic growth is not adequately reflected in earnings forecasts. The US is still predicted to grow profits approximately 7.5% per annum over the next three years (including 2022). This remains difficult to reconcile with an expected decline in economic growth which typically sees profits fall. If earnings disappoint further, as would seem likely over coming quarters, then the risk of further market weakness 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 and volatility in energy prices amongst others.
On balance we believe the case for being underweight global equities continues to be justified with meaningful risk of downgrades to future earnings growth and further derating on the back of rising interest rates. Accordingly, we maintain our underweight position in global equities.
In the United States, operating earnings for S&P 500 companies are currently expected to rise by 6.2% in 2022, 6.8% in 2023 and 9.5% in 2024. Assuming conventional long-term multiples, we estimate that the United States share market (as measured by the S&P500) is overvalued by 8.8% in the near-term and undervalued by almost 7% in the medium-term.
|2022 calendar year forecast||EPS earnings estimates (US$)||S&P 500 fair value estimate||Upside/(downside) S&P 500 = 3852.4|
|If 10% below||197.6||3161.2||-17.90%|
|If 10% above||241.5||3863.7||0.30%|
|2023 calendar year forecast||EPS earnings estimates (US$)||S&P 500 fair value estimate||Upside/(downside) S&P 500 = 3852.4|
|If 10% below||210.9||3374.5||-12.40%|
|If 10% above||257.8||4124.4||7.10%|
|2024 calendar year forecast||EPS earnings estimates (US$)||S&P 500 fair value estimate||Upside/(downside) S&P 500 = 3852.4|
|If 10% below||231||3696.3||-4.10%|
|If 10% above||282.4||4517.7||17.30%|
Source: Bloomberg consensus estimates for 2022, 2023 and 2024 as of 20 December 2022.Over the quarter we saw a rerating of share prices even as earnings expectations declined. Two factors have been key. First, the deceleration of US inflation and poor macroeconomic data has seen a return to the “bad news is good news” narrative whereby investors are anticipating the Fed to halt or even cut rates sooner than previously anticipated to offset weaker economic growth. Second, the conclusion of China’s “Zero Covid” policy saw a pickup in optimism for emerging markets and resources stocks in anticipation of supportive economic policies and stronger Chinese resource demand consequently.
12-month Forward Price-Earnings Ratios for major markets (Dec-05 to Dec-22)
Recommendation: Maintain underweight.
|Region||Forward PE||15-year Average Forward PE||Potential upside/downside|
|All Country World (ex-US)||12.0x||13.9x||16.00%|
In spite of more attractive valuations, we expect consensus earnings expectations remain overly optimistic and are likely to fall as global growth slows materially given challenges posed by inflation, rising interest rates and coronavirus cases in China. For these reasons we remain underweight.