With economies getting stronger and interest rates nearing their peak, the environment looks supportive for equity and bond markets, but emerging markets face challenges. Sunil Krishnan assesses the implications for multi-asset investors.

Read this article to understand:

  • The themes that have shaped markets in the first half of 2023
  • Why emerging markets face headwinds
  • What this means for multi-asset portfolios

Coming into 2023, it was difficult to take a strong view on the direction of either equity or bond markets. Instead, multi-asset portfolios were shaped by idiosyncratic views on sectors and regional economic themes. This has changed significantly in recent months.

The risk of a deep recession has faded and monetary policy tightening is nearing its peak. Meanwhile, slower activity in China, following its pandemic reopening boost, is creating headwinds for emerging markets. This has several implications for multi-asset investors.

Key themes

The outlook for financial stability and growth is improving. The banking panic is subsiding and not turning into systemic contagion. Credit conditions might tighten as banks reassess their risk appetite in a world of higher interest rates, but that is not the same as a domino effect among failing banks (see “Perfect storm or storm in a teacup?”).1

At the same time, measures of economic activity and some inflation data have been stronger than expected for developed markets this year. As a result, after declining in the last quarter of 2022 and first quarter of 2023, investor sentiment towards company profits seems to be stabilising.

In addition, while some countries may see further 25- or 50-basis-point interest rate rises in the coming months, the tightening cycle looks to be entering the late stage. That has important implications for bonds, where the scope for large rate rises is much reduced. A less volatile bond market should support a broad range of financial markets, so investors should not face the same challenges as in 2022.

Figure 1: ICE-BofA MOVE Index of US Treasury implied volatility (basis points)

Source: Aviva Investors, Bloomberg. Data as of June 13, 2023

The third theme is that, judging by a string of economic data, China’s reopening appears to be struggling to build up a head of steam. The consensus view that western economies are more challenged by their banking systems, while China’s economy is strengthening, is being called into question on both fronts. However, while sentiment on China has deteriorated, it has not reached the stage of panic we have sometimes seen in the past.

Our concern is sentiment for emerging markets tends to oscillate between extremes, so panic could emerge, even if it is ultimately unjustified or policy becomes more supportive. This concern is reinforced by our view China is not on the cusp of providing strong policy support for the property market, demand or infrastructure spending. As a result, we have shifted portfolios from overweight to underweight positions in emerging markets, which face several headwinds.

Emerging market headwinds

The first headwind is the lack of improvement in China’s property market. Dollar-denominated high-yield bonds from Chinese real estate issuers have fallen back after a sharp rally in Q4 (Figure 2).

Figure 2: iBoxx China real estate high yield return index (US$)

Source: Aviva Investors, Bloomberg. Data as of June 16, 2023

The market isn’t at rock-bottom, but it has not moved the way it should have if it were receiving material policy or demand support. Again, there have been limited moves from the authorities and no suggestion from China’s first-quarter monetary policy report we should expect more support.

That is a reason why consumer confidence in China has been relatively weak, despite the fact economic activity since reopening has been more focused on consumer spending than on industry and infrastructure spending.

A second challenge for emerging markets is a return to declining consensus estimates for forward earnings, after a slight improvement between mid-January and mid-February. We expect some stabilisation from here, but it is not a bullish case.

A second challenge for emerging markets is a return to declining consensus estimates for forward earnings

This is in stark contrast to the US, which ended 2022 on a downgrade cycle for earnings estimates but moved back to upgrades in April and May. As SVB and US regional banks grabbed the headlines, most investors would have expected the tenor of US revisions to remain negative for the first half of the year and be more supportive for emerging markets, so this is an important contrast.

And while it is not all specifically related to China, the extent of EM dependence on China in terms of performance goes beyond the 27 per cent of Chinese companies listed in the MSCI Emerging Markets Index. It might include the sensitivity of South Korea and Taiwan as key component suppliers to Chinese electronics manufacturing – and to Chinese demand in phone-handset production, for instance.

Another example is Latin American commodity producers that can be affected if a key source of sentiment on commodity prices from China turns, particularly in metals markets. Valuations of Latin American stocks have not seen increases in ratings this year, a key driver being their weighting towards export-oriented sectors like commodities and industrials.

Figure 3: 12-month forward earnings estimates (index US$)

Source: Aviva Investors, Bloomberg. Data as of June 20, 2023

The third headwind is the difficult choices some of the largest EM companies may have to make in the medium term between demand in the West and in China.

Some companies are enjoying more of a tailwind today. For example, semiconductors producers in South Korea and Taiwan have allowed those countries’ markets to keep pace with developed markets. It is reasonable to expect the upswing in semiconductor demand to persist into next year globally.

However, this may not last. China imposing restrictions on the use of US Micron chips domestically is helpful for non-aligned producers in the short term, but in the medium term our concern is that it may prove too much of a high-wire act.2

Relative US strengths

In contrast, while earnings estimates for US equities were too high in the last quarter of 2022, they have come down significantly since then, while first-quarter earnings and sales figures surprised those expectations to the upside.

Expectations were for Q1 S&P 500 earnings to be about nine per cent lower than the same quarter last year. They were lower, but only by 2.75 per cent. Of course, companies typically try to position themselves to be able to create a positive bias of surprise versus earnings expectations. But earnings surprised for all sectors apart from utilities, and sales surprised for all major sectors in the US.3

Two important themes emerged in first-quarter earnings announcements. One was the willingness of big tech companies to manage costs to maintain profits. The second, in terms of positive sales surprises, was the ability of companies to continue to manage pricing in a way that didn't damage demand. Higher input costs and multiple rounds of price increases did not prevent aggregate top lines from growing, which was surprising given the general expectation late last year that Europe would enter recession and the US would suffer a severe slowdown.

Equities still face challenges, including concerns of unwarranted euphoria surrounding AI related names

Equities, particularly in the US, still face challenges, including concerns of unwarranted euphoria surrounding artificial intelligence (AI) related names. For example, AI leader Nvidia’s share price climbed by over 30 per cent in three trading sessions in late May.4 This prompted concerns the breadth of performance in the US stock market is too narrow.

As an example, year-to-date, the equal-weighted S&P 500 index is flat or even slightly down, which some commentators see as evidence of the lack of a broad-based upswing. In contrast, we think this represents a rather unloved equity market rally. Indicators of sentiment for equity markets overall remain cautious rather than euphoric.

And while the past is not an indicator of future performance, concerns about market breadth have not tended to be a lasting problem. In 2020, performance of the equal-weighted S&P 500 was flat between the start of June and the start of November, but then rose by 50 per cent through to the end of 2021.

Narrowly based gains in the US market rightly make investors focus on the underlying profitability of other companies, but there is no reason why we should see the bulk of companies sucking successful ones back into their lower orbit rather than a broader range of companies performing better. Again, the base of expectations for earnings is lower than it was, and profit margins have come down, reducing the risk of reversion. If companies continue to eke out gains, sentiment towards the market should gradually improve.

Figure 4: S&P 500 EBITDA margin (per cent)

Source: Aviva Investors, Bloomberg. Data as of June 20, 2023

The caveat of course is a deep recession would reduce company profits, but the timeline for this risk looks more long than short term. In addition, companies are much less overextended in terms of their investment programmes than they have been ahead of previous recessions.

Figure 5: S&P 500 capital spending to sales (per cent)

Source: Aviva Investors, Bloomberg. Data as of June 20, 2023

Portfolio implications

The key market themes discussed above – fading risk of a deep recession, getting closer to the peak in policy tightening and EM headwinds – are broadly supportive for equities and bonds. As a result, we are overweight in both the equity and, broadly speaking, bond markets. Our positions are also much more directional than they were at the start of this year, with outright overweights rather than relative-value positions.

Given the comparative evolution in US and EM equity markets, however, we have added to US equities to some degree, both in outright terms and by switching our EM versus US position, so we are now overweight US versus EM equities.

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