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The perils of a narrow stock market rally

13 September 2023

Western recession remains our base case and we are still relatively defensively positioned.

By Alison Savas,

Antipodes Partners

We’ve had the FAANGs, the MAGMA stocks, and now it’s the so-called Magnificent 7 – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. These seven stocks have contributed half of the performance in global equities this calendar year and as much as 70% of the S&P’s rally, taking the latter to just 5% from its all-time highs.

While it does feel like the growth trade is back, the equity rally has become increasingly unbalanced and such narrow performance doesn’t necessarily indicate animal spirits are alive and well.

We’re not seeing a return to the broad-based growth-at-any price duration bubble we saw in 2021. Real rates are 1.6% and rising, not 0% or negative real rates seen from 2020 to 2022, which supported the duration bubble.

But we’re also not seeing outperformance of the more traditional defensive sectors either.

Instead, we’re seeing performance of a very narrow subset of stocks that are perceived to be both defensive and have structural growth prospects.

There’s a continuum of outcomes between a hard landing (recession) and a soft landing. At the margin, it does looks like the market is tilted to the soft-landing scenario and pricing in an improvement in the growth/inflation mix.

That is, the market is saying growth will remain relatively resilient while inflation recedes and that the Federal Reserve will ultimately be able to gently ease off the brakes as opposed to slamming them on to avoid a recession.


What is already priced in

US equities are priced at 23x the prior 12-month earnings, which is 10% more expensive than the average multiple over the past 10 years. Additionally, consensus forecasts assume 2023 earnings will be flat on a year-on-year basis, despite the tightening that’s already in place, and consensus is factoring in a 14% increase in earnings in 2024.

The juxtaposition is we’re just beginning to see the lagged effects of monetary tightening on credit growth and the lead indicators continue to point to a weaker growth outlook.

Money supply is contracting faster than ever due to quantitative tightening and tighter lending standards and the capital position of banks remains under pressure.

The lags to monetary policy range between 12 – 18 months so the full impact is yet to be felt. This will be challenging for growth. The service sector, which has been supporting economic activity globally, is losing momentum, and manufacturing, construction, house prices and world trade still remain under pressure.

If the leading indicators are correct, we could see a 15% drawdown in US earnings, which would see US equities reach 26x earnings. This is a substantial premium to its own history and the rest of the world, which has already gone through an earnings downgrade cycle.

Valuations in Europe and China are closer to 13-14x earnings, hence the margin for error in US equities is high. We think activity will continue to slow, and there’s a risk that the Fed overtightens or takes too long to pause as it focuses on wage inflation.

Where could the positive surprises come from

Despite the data, the most anticipated recession in the West is yet to arrive. Non-residential investment has remained more resilient than the manufacturing sector. This could be related to policies around decarbonisation and supply chain security such as the Inflation Reduction Act and the CHIPs Act in the US.

If non-residential construction growth proves to be more structural it will provide some support to economic activity and we are tracking this closely.

Upside could also come from more policy support, with China the likely candidate. While the absence of a co-ordinated policy response to date has surprised us, particularly given the Chinese economy is facing deflation, a lack of improvement in the domestic economy or further weakening in the global economy should make policy makers push towards more stimulus given meaningful firepower to act and a risk of social instability if the labour market fails to recover further.

Youth unemployment is 20%. Additional stimulus won’t just support a domestic recovery, the size of the Chinese economy means it can also change the global economic outlook even without the big bang stimulus of the past.


Our portfolio positioning

Western recession remains our base case. We’re still relatively defensively positioned with a focus on containing the global portfolios’ exposure to cyclicality in preference for attractively priced growth and quality, while maintaining our tilt to value.

If the leading indicators evolve to suggest the Fed can engineer a soft landing, by-passing recession altogether and culminating in a dovish pivot, or if there is a broadening out of performance in the equity market, it will become more appropriate to lean into our cyclical exposures e.g. beneficiaries of policies that address climate change and supply chain security (on/near-shoring).

While these investment cycles may already be underway we are still in the early stage of this secular shift and many of these businesses are not efficiently priced, particularly outside of the US.

Alison Savas is an investment director at Antipodes Partners. The views expressed above should not be taken as investment advice.

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