Equity Outlook: Stubborn Market Risks Warrant Broad Positioning

Global equity market weakness in the third quarter reflects the uncertain outlook. We address some of the big questions on investors’ minds.

With the trajectory of the world economy hanging in the balance, global stocks faltered in the third quarter. Many investors have real concerns about the current environment. But we think there are good reasons to stay actively invested in stocks with a strategic eye on the lingering risks.

After rising in July, global stocks fell in August and September. The MSCI ACWI Index ended the quarter down by 2.5% in local-currency terms (Display), taking its gains for the year to 11.2%. Japan outperformed, as companies benefited from an end to the country’s persistent deflation problem. US small-caps underperformed. Chinese stocks declined amid worries about growth in the world’s second-largest economy.

Technology stocks slipped after a strong first half (Display). Energy was the best-performing sector in the quarter, as oil prices rose, driven by tighter supply conditions. Value and minimum volatility stocks fell less than growth stocks in the quarter. However, growth stocks have still outperformed by a wide margin in the year through September. 

Tug of War: Macro Fear vs. AI Fervor

Market returns in 2023 reflect a curious combination of conflicting sentiment. Investors have been caught between uncertainties over the macroeconomic outlook and excitement over the potential of artificial intelligence (AI) to buoy growth for select companies. Until the third quarter, enthusiasm for AI took center stage, particularly in the US, where the 10 largest stocks dominated returns.

Is the pendulum swinging back toward macro issues?

While inflation has fallen, investors understand that interest rates are likely to stay higher for longer than expected at the beginning of the year; this means real rates are higher, which usually puts pressure on equities. Still, growth and policy nuances differ substantially by region.

High hopes for China, which was fast to recover from the COVID downturn, have faded even faster amid waning consumer and business confidence, housing sector imbalances and little sign of government stimulus. The European Central Bank raised rates in September and regional recession fears are acute, particularly as German manufacturing suffers from sluggish Chinese demand. In the US, where consumer spending has been resilient, conditions are fragile and an adverse event—such as an end to student loan forgiveness—could complicate the outlook. Still, the Federal Reserve kept interest rates on hold in September and its latest forecasts suggest that a soft landing for the economy is likely.

Against this backdrop, equity investors are asking big questions. Why invest in stocks when interest rates are likely to stay higher for longer? Should you position for deeper macro stress or a softer landing? How do you gauge earnings and valuation risk in what has been a narrow market for most of the year?

Why Invest in Stocks at All?

In today’s market, it’s easy for investors to be tempted away from risk assets. With cash deposits offering interest of more than 5%, why take a risk on stocks? We understand the short-term appeal, but for long-term investors, we think there is a big opportunity cost to be paid for taking the risk-free route.

Equities are also a source of income—a key focus for many investors in today’s inflationary environment. While dividend yield is a common measure of equity income, we think free-cash-flow (FCF) yield is a better gauge. The FCF yield is the excess cash that a business generates after deducting all operating costs.

Today, the FCF yield on global stocks is lower than corporate bonds or cash (Display). But project forward and the picture looks different. Based on consensus forecasts, an investor in global stocks would just have to wait one year for the FCF yield to nearly catch up with the yield on the Bloomberg Global Aggregate Index of corporate bonds. And over time, we expect the yield gap to widen. 

In other words, our research suggests that equities offer an improving cash-flow income yield over time relative to the fixed income of corporate bonds of equivalent issuers. We believe capturing this potential is especially important in a world where investors need to generate real returns above inflation to reach long-term financial goals. Both stocks and bonds are better than cash, as current high interest rates are unlikely to endure, according to Fed projections, so investors will struggle to maintain returns when reinvesting. Cash hasn’t beaten inflation for any of the past 12 years.

How Can You Position in Equities for More Macro Stress?

Markets have been relatively relaxed about the economy this year. Yet if GDP growth slows and market volatility strikes again, investors will face more difficult conditions.

But growth isn’t only about the economy. Investors can find trends and themes that are likely to continue to grow at a relatively rapid clip, even if GDP growth slows. In the global push for a greener world, a structural shift is underway, fueled by massive public funding to support industries such as alternative energy and electric vehicles (Display). Global adoption of digital payments is unlikely to ebb, and mobile data traffic is on the rise. In healthcare, DNA sequencing and digital health data are on course for robust growth in the years ahead. 

Similarly, being defensive isn’t only about utilities and consumer staples. Companies with distinct competitive advantages can better sustain their margins. Businesses that are run with strong FCF generation and lean balance sheets maintain flexibility to weather periods of macro weakness. In combination, we believe that looking for growth in areas supported by secular trends and resilience through companies with strong fundamentals can be a powerful recipe for active managers to generate strong long-term returns.

What’s the Real Risk—Valuation or Earnings?

While macroeconomic news often influences markets, long-term equity performance is ultimately a simple function of two variables: the earnings or cash flow of the companies you own, and the price you are willing to pay for it.

Some of the US mega-cap stocks that surged this year have strong earnings potential owing to business dominance and AI leadership positions. But does access to their earnings streams justify very high valuations? In some cases, yes. But the answer varies from company to company and it’s still too soon to fully understand the sustainability of AI-driven earnings. For investors who are exposed to the entire group via passive allocations, we believe valuation risk is greater than earnings risk.

High valuations can end in a painful correction, as we saw in the 2022 bear market. And higher interest rates warrant a greater focus on valuation, not only between different equity styles but within them. If higher rates eventually put pressure on mega-cap valuations, other growth companies may be more attractive. In today’s conditions, we believe that it’s especially important to search for a wider array of companies that have less valuation risk and offer solid earnings prospects.

Can investors find a better balance of valuation and earnings risk? We think so. Across an array of industries, we’ve found that company balance sheets are generally in much better shape today than before previous economic slowdowns, which should support earnings resilience if macro conditions deteriorate. Reasonably valued stocks with attractive long-term growth potential can be found in diverse sectors, in our view.

Take the healthcare sector, which has underperformed so far this year. US healthcare stocks trade at a price-to-forward-earnings ratio of 16.5x, based on 2024 earnings estimates—a 5.5% discount to the S&P 500 benchmark’s valuation. The sector also offers attractive FCF yields compared to the market. Within healthcare, active investors can avoid riskier, unprofitable smaller biotech companies, and focus on select stocks that offer a solid combination of long-term growth and defensive characteristics.

Globally, value equities have been out of favor in 2023. These stocks trade at deep discounts to the broader market and are perceived as being more exposed to a cyclical slowdown. Yet value companies can be found that are less vulnerable to a recession and benefit from long-term trends including onshoring, the energy transition and even AI. In the technology sector, many high-quality, profitable companies that operate behind the scenes don’t face the same risks as the consumer-facing giants and offer more attractive valuations.

Strategies invested in these types of companies may have trailed the narrowly driven market so far this year, but we think they offer investors a more solid foundation for the future. When attention has been focused on a small group of stocks, we think investors should cast a wider net for companies that benefit from secular trends and are less exposed to an economic downturn, which may be found in sectors that are out of the limelight. Maintaining focus on attractively valued companies with diversified sources of revenue and earnings growth can help provide access to the long-term power of equities—while reducing some of the short-term risks.