Developed Markets Quarterly Outlook
February 2023*
Navigating a Desynchronized Cycle
The disinflationary trend and peak in rates is providing comfort for the market, but headwinds persist and limit the potential for a sustained rally in global equities. Central banks will continue to play a significant role as monetary policy remains a constraint due to its lagged effects on global activity data. Regional growth and earnings divergences will likely result in relative value opportunities.
Since our last Developed Market (DM) outlook, China’s growth forecasts have improved, inflation has moderated, and financial conditions have loosened. International equity markets responded positively, reflected in the 11% rise in the All Country World Index (ACWI) over the quarter. While the improvement in the cycle justifies some stabilization in global equities, headwinds persist and hinder a more robust rally this year.
The Federal Reserve and other major central banks continue to tighten policy as inflation tracks above target rates. We think the rates market is correctly anticipating a peak in rates following 450bp of Fed hikes. However, we have a low probability of a soft-landing that sets the stage for a more sustained bull market. Instead, we suspect the lagged policy impact from past tightening will lead to further earnings contractions. Disinflation will provide short-term support for equities, but sentiment will likely fade by mid-year once this disinflationary trend subsides. Using history as a guide, the US and European equities bottom about 1-1.5 years (on average) following the last Fed rate hike based on the previous seven hiking cycles.
While global earnings will remain under pressure, market positioning does not indicate excessive exuberance that typically precedes sharp sell-offs. In addition, the rebound in China’s economic growth sets the stage for a desynchronized economic and earnings cycle, driving flows to markets with stable earnings and attractive valuations. With elevated equity multiples and contracting earnings, the US index will face challenges. Emerging Markets (EM) and commodity-linked markets are better options than the Eurozone, where ECB tightening will result in earnings downgrades, and energy scarcity issues may resurface later this year.
Market Strategy: In our country allocation, we seek balanced exposure to various potential outcomes. We prefer to avoid excessive exposure to either pro-cyclical or defensive countries/sectors in light of a desynchronized global cycle. Instead, we identify attractive relative value opportunities. Since our last Quarterly Outlook, we have made the following allocation changes:
- Upgrade EM to overweight from neutral. The outlook has improved with global inflation moderating, EM Asia growth improving, and improving financial conditions. We expect the MSCI EM’s higher IT weighting to benefit from a peak in global rates.
- Downgrade US to neutral from overweight. The upgrade to growth in the Asia region will likely continue to attract flows to non-US markets resulting in a further de-rating to the US market this year. However, we are not inclined to be under weight in the US market as we approach a peak in US rates.
- Maintain the Eurozone underweight. Despite cheap valua- tions and light positioning driving a sharp rally last quarter, these technical factors are now less supportive. Growth head winds and energy scarcity risks persist, and we expect earnings to decline this year following ECB policy tightening.
- Maintain the UK, Canada, and Australia overweight positions. The moderation in commodity prices from the mid-2022 peak has cheapened these markets. A lift in Chinese demand and a weaker USD also improve the broader commodity outlook. We continue to see value in these indices. Switzerland remains underweight with a high forward P/E multiple. Japan remains neutral, with Japanese rates and FX volatility expected to remain elevated.
Global Equity Allocation Breakdown
| Chg | -2 | -1 | 0 | +1 | +2 | |
| US | ↓ | |||||
| Canada | - | |||||
| Eurozone | - | |||||
| Switzerland | - | |||||
| UK | - | |||||
| Japan | - | |||||
| Australia | - | |||||
| EM | ↑ |
*This publication reflects asset performance up to 31 January, 2023, and macro events and data releases up to 10 February, 2023, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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