We believe global equity markets are facing crucial turning points, with several powerful trends that have driven markets over the last two decades seemingly at an inflection point. This will have significant implications for future market leadership.
Interest rates, which have been on the decline for nearly four decades, have increased sharply as central banks have sought to rein in surging inflation over 2022. Lower rates had cut the cost of capital driving valuations higher, particularly those of growth stocks. Meanwhile, the US dollar has recently fallen from its 20-year high as signs of inflation easing have fuelled speculation that the Fed will have to pause rate hikes.
This backdrop has already driven a dramatic change in markets with high-growth tech stocks selling off. Value stocks and sectors have started to outperform, and this could mark the start of a more sustained shift in market leadership.
Where next for valuations and earnings?
The Fed’s aggressive rate hiking cycle and quantitative tightening has led to a huge withdrawal of liquidity, leading to lower asset prices. US equity valuations are currently back to pre-pandemic levels, but are still slightly expensive compared to history, and close to long-term averages elsewhere.
Valuations are normalising
Source: Fidelity International, Bloomberg, 31 December 2022. The long-term P/E ratio chart shows regional equity markets relative valuation comparison across multiple business cycles with latest twelve-month forward price/earnings consensus estimates.
The next leg of the story for equity markets is likely to be driven by earnings. After a period of above-trend earnings growth and profit margins, we think an earnings correction is likely in 2023. We’re already seeing some early signs. For example, companies have started to guide more conservatively; we’re starting to see profit warnings among some early-cycle industries like consumer discretionary and there are increasing layoff announcements. These are clear signs that companies are feeling the pressure on profit margins.
A 20% correction would be in line with previous earnings downcycles observed over the last 50 years and would see earnings fall back to long-term trend-growth. This is a reasonable base-case scenario to us. The good news is this correction started last year and as more visibility emerges on the likely path of earnings over the coming months, we expect equity markets to resume growth in 2024.
Earnings drawdown coming
Source: Citi Research Global Equity Strategy, DataStream, 3 November 2022. The recreated chart shows the past 50-year global equities EPS data trend during the last 7 recessionary periods.
A watershed moment for sustainability
In an unpredictable world, the big question for investors is where can they find more certainty? We believe sustainable stocks provide this certainty and visibility as they address some of the biggest challenges we face as a global society - issues that need to be fixed, regardless of the short-term market outlook.
Our belief is that companies addressing some of our greatest environmental and social challenges will enjoy strong demand growth and stand to earn higher and more durable returns over time as a result. By being on the right side of policymakers and regulators they are also likely to enjoy lower long-term risk profiles. These companies therefore have potential to deliver strong returns to shareholders, whilst also being a driving force for positive societal change.