Brandywine Global on the US & global equities outlook

by | Jul 19, 2023

U.S. Equities Outlook – Halfway There, Livin’ on a Prayer?

By Patrick Kaser, Managing Director & Portfolio Manager, and Celia Hoopes, Portfolio Manager & Research Analyst 

“As we think about U.S. equity market performance year to date and reflect on the trajectory for the second half of the year, we cannot help but be reminded of Jon Bon Jovi’s hit song, “Livin’ on a Prayer.”

“One of the most widely forecasted recessions has yet to come to fruition. For months, the debate has been between a “hard landing” versus “soft landing,” but now the possibility of “no landing” has entered the range of potential outcomes. On first quarter earnings calls, many management teams were optimistic about the second half of the year. We have a tough time being as hopeful.

“According to some definitions, we are now in a bull market, but as every market commentator will surely remind you, the breadth of the rally is one of the narrowest on record. The 10 largest stocks in the S&P 500 accounted for nearly 90% of the index’s year-to-date returns, the highest percentage in history.1 Earnings growth has become scarcer, and the premiums investors are willing to pay for those companies with it have skyrocketed. Indeed, price-to-earnings (P/E) expansion as opposed to an improvement in earnings outlook has been the primary driver of market performance. Earnings estimates for the year have risen from the beginning of April but remain lower than consensus estimates at the beginning of the year.

“We see a myriad of headwinds as we enter the second half. Household excess savings have been worked down with Morgan Stanley estimating, based on Bureau of Economic Analysis data, that those for the lower-income quartile were exhausted by the end of the first quarter.2 Beginning in September, student loan repayments will resume, which some sources estimate will be a $128 billion to $148 billion annualized headwind on consumer spending.3 The Bureau of Labor Statistics reported that April’s core CPI was 0.4%, which was in line with consensus expectations, but this rate annualizes to nearly 5%. While prices for core goods, excluding used vehicles, were nearly flat, price inflation for services remained persistently strong. It will take a weaker labor market for services inflation to slow. The debt ceiling debacle has come to an end, but the Treasury needs to refill its coffers, which likely will create a drain on liquidity.

“There have been 12 Fed tightening cycles since 1960, 8 of which have resulted in hard landings and 4 of which have resulted in soft landings, according to Piper Sandler.4 The recipe for the former tends to be underscored by a sharp deterioration in unemployment while the latter experiences little to no downturn in employment. Piper Sandler also writes that precursors to a hard landing have been rapid Fed hikes coupled with tight bank lending standards and sticky inflation while precursors to a soft landing have typically consisted of modest Fed hikes, easing bank lending standards, and low inflation.4 Current conditions seem very similar to those that preceded hard landings in the past.

“We never wish for market downturns, but we believe it is prudent to be positioned more defensively at this time.”

1 Bernstein Research, “Tech Strategy: The Most Concentrated Market Ever…What Does History Say Happens Next?”, A.M. Sacconaghi, Jr., A. Larson, A. Murdia, D. Zhu, June 12, 2023

2 Morgan Stanley Research, “US Economics Mid-Year Outlook: Soft Landing Summer Camp,” E. Zentner, D. Anzoategui, S. Wolfe, L. Dujon, R. Heymann, June 7, 2023

3 KeyBanc, “Consumer/Retail Hardlines Industry Update,” B. Thomas, Z. Donnelly, T. Zick, June 4, 2023

4 Piper Sandler, “Second Half Outlook: What Could Go Right & What Could Go Wrong?”, June 6, 2023

Global Equities Outlook – Europe and Asia Quietly Take the Baton

By James Clarke, Portfolio Manager & Director of Fundamental Research, and Sorin Roibu, Portfolio Manager & Research Analsyt

Our favourite chart on global markets shows the long cycles of U.S. outperformance and underperformance (see Figure 1). These cycles can last years as investors who fell in love with an investment theme or geographic region reluctantly unwind their overweight positions.

“In 2022, a nearly 14-year cycle greatly favouring the U.S. appears to have ended, which has left both the U.S. stock market and the dollar very highly valued relative to alternatives, but no longer outperforming. The U.S. underperformed in 2022 and even in the first quarter of 2023, which was supposedly led by U.S. tech, but European markets quietly did even better (see Figure 2).

“We are looking to places like Europe, China, Japan, and Korea for future equity market leadership. These markets are far cheaper than the U.S., even for very similar global companies. These regions are all deeply out of favour with investors but for different reasons, enabling a degree of potential diversification.

“European stocks have done well since last September as the bear market case of a crippling energy crisis simply did not happen. Investors remain cautious, however, so stock prices are relatively attractive. China draws fear from investors, mainly about geopolitical risk, yet many of those same investors appear quite comfortable owning large U.S. tech companies completely dependent on Taiwan chip production. Chinese internet mega caps are among the cheapest stocks in the world, trading at single-digit price-to-earnings (P/E) ratios.

“In Japan and Korea, we would expect to capitalise on appreciation in the currency as well as the stocks. In Japan especially, the currency is clearly undervalued with everyday items in Tokyo costing half what they cost in New York City.”

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