Markets appear disjointed from worsening economic fundamentals. Experts show what investment to avoid and where to look in 2H2023
Despite fears of a recession, many stock market investors have chosen to look ahead, beyond or away at what is happening in the broader real economy and chase after the latest hot stocks.
This year, the S&P 500 and the Dow Jones Industrial Average are up 11.6% and 1.6%, respectively, as of June 7. More notably, chip designer Nvidia, following bullish sales projections after positioning itself as a leader in AI, became one of the few companies valued at more than US$1 trillion ($1.35 trillion). As the hype drove punters to place big bets on Nvidia and smaller bets on other tech counters, the techheavy Nasdaq was lifted by more than a third in the year to date before dipping to gain 26.2% as of June 7.
AI can seemingly help investors ward off the real pain inflicted by the US Federal Reserve, which is set to keep rates higher as it prioritises its ongoing struggle with inflation over market gains.
Meantime, US consumers are still spending, providing some support for what was supposed to be a gloomier outlook. This has prompted the widely cited Conference Board to upgrade its US GDP forecast for these two coming quarters. Despite the rosier forecast, the US economy is still expected to contract by 0.6% for the current 2Q and dip further by 1.6% in the subsequent 3Q.
Market commentators warn that financial markets appear to be disconnected from economic fundamentals. Strategist Rajat Bhattacharya of Standard Chartered Bank’s wealth management unit writes: “Parts of the equity market are in the grips of a frenzy seen during the dotcom bubble in the hope that generative AI is about to transform the world sooner than many expect… Meanwhile, underlying fundamentals in Europe are deteriorating, while China’s post-pandemic burst of activity is fading.”
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Bob Savage, head of markets strategy and insights at BNY Mellon, observes similarly: “Water and electricity do not mix. Neither do stocks and economic disappointments.”
The seemingly cheerier-than-expected indicators belie dangers just around the corner. Citi Global Wealth Investments notes that persistent demand for services and “labour hoarding” has led to US employment gains for May to be nearly twice as large as expected, with hiring not merely from hotels and restaurants in a post-pandemic hiring spree. Construction, trade and retailing — industries that are weakening — all saw gains in employment while manufacturing employment fell only slightly. Yet, Citi warns that recessions are unfolding in manufacturing, trade and residential construction sectors.
Despite negative investor sentiment and bearish positioning, equities have gained on the expectation that labour market gains can “outlast” the Fed’s tightening impacts on the broader economy. Under a so-called “rolling recession scenario” where different sectors go down and recover at different points, the economy may escape a broad-based plunge, suggests Citi.
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Citi adds: “Nonetheless, we are sceptical that recessionary industries under considerable profit pressure will be able to maintain their hiring pace. With falling inventories and reduced demand, we believe a net slowdown in employment remains ahead. Booming industries, such as travel and leisure, will eventually slow, too.”
As such, market analysts are not optimistic that equities, especially the US markets, will continue to do well. “Equity markets have performed better than many expected so far this year, arguably reflecting better-than-expected macro news flow against a prior backdrop of low investor sentiment and positioning,” says Citi.
Morgan Stanley warns that the US economy will “slow materially” over the next few quarters, as flagged by weakening commodity prices. “While the prospect of slower growth ahead is bad enough, our forecasts suggest that stocks will also have to contend with a stronger US dollar and a less dovish-than-previously-hoped stance from central banks.”
In addition, Morgan Stanley expects earnings to disappoint as revenue growth slows and margins contract further, with a 16% y-o-y earnings contraction seen for the S&P before a rebound next year. The earnings “downgrade cycle has been delayed, not derailed”, adds the US bank, whose 12-month target for the S&P is 4,200 points and is therefore “underweight” on US stocks.
For StanChart’s Bhattacharya, May’s strong US jobs data has raised the chance of another Fed rate hike in June or July instead of merely holding at current levels. “However, global economic activity, mainly in manufacturing and trade, continues to slow. This is reflected in the slump in crude oil and copper prices. The Euro area and China data have underwhelmed lately, adding to concerns. Germany has already entered a technical recession. Our base case is a rate pause and a US recession starting in 4Q. This is likely to crimp corporate earnings, dragging down equity markets.”
With further deterioration in global economic activity, Bhattacharya expects limited stock upside. “We would use the latest rally in equities to rotate to more defensive assets, especially developed-market investment-grade government bonds, where yields are now more attractive than a month ago. Those excessively exposed to technology sector equities after the latest rally should consider rotating into more defensive sectors,” he warns.
Regional forecasts for equity market earnings, valuations and index targets: Morgan Stanley
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In what is dubbed the “heading south, looking east” theme, Morgan Stanley believes that the best opportunities now are in Asia, especially Japan, where there is a combination of improving ROE outlook, growing buybacks, and attractive valuations underpinned by growing global investors’ interest.
Meanwhile, despite the clear fizzling out of the post-pandemic reopening rally, China is still deemed an attractive market. “We see outperformance of Chinese equities resuming in the second half of 2023 as easing steps up, macro recovery broadens out, and geopolitics stabilise,” says Morgan Stanley.
Recent economic data, such as the 7.5% y-o-y drop in trade for May released on June 7, has spooked investors. To Morgan Stanley, such data is a sign of “uneven and unbalanced recovery” and not the end of the up-cycle. “We also expect policymakers to step up easing measures around late June or early July and a consumption-led recovery to broaden in the second half this year as the job market and income levels recover. These upcoming developments should help earnings cut the bottom out before re-accelerating in 3Q this year,” adds Morgan Stanley.
As the market and economic cycles go, there is usually something cheerier to look forward to. “While a recessionary backdrop would be most problematic for equities in the short term, it at least offers the potential for a bigger drop in inflation and subsequent recovery thereafter,” says Morgan Stanley.
In the following pages, The Edge Singapore’s editorial team shares what market experts see in greater detail.
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