Thought of the day

The fourth-quarter earnings season, which is virtually finished in the US and 60% complete in Europe, shows corporate profits are slowing by less than feared several months ago.

But we continue to expect a 5% fall in US and Eurozone profits in 2023 and a 3% contraction at the global level. This suggests further modest downgrades to consensus earnings forecasts, which currently stand at around 0–2% for these three markets. Earnings prospects and unattractive valuations support our view that global equities will struggle to make significant gains from current levels:

  • Leading indicators point to a US earnings recession. US 4Q22 earnings are on track to contract year-over-year, and a subsequent decline in 1Q23 numbers would tip the US market into an earnings recession. Weakness in leading economic indicators alongside rising margin pressures point to further downside to earnings. The Federal Reserve’s Senior Loan Officer Opinion survey, for example, suggests that banks have tightened lending standards on commercial loans to an extent that has historically been associated with an earnings contraction and rising US corporate defaults.
  • Earnings downgrades look manageable. In 24 of the last 35 years, consensus global earnings expectations have been too optimistic and modest downgrades are the norm. Global equities have still been able to post gains in 15 of those 24 years. But after the strong equity rally in recent months, we see limited further near-term upside in the absence of a more positive outlook for growth than we currently envisage.
  • Equities are unattractively valued relative to bonds. On valuations, global equities are trading at a 7% premium to the 20-year average forward price-to earnings-ratio of 14.5x, which is unwarranted given the earnings drop we project. In relative terms, we think global equities remain unattractive compared to high grade bonds as depressed equity risk premiums and the cost of equity are consistent with future negative returns versus high-quality sovereign bonds.

So, at the overall index level, we see limited upside potential for global equities and our end-2023 forecast for the MSCI All Country World index is 770, compared with the current level of 760. This suggests a balanced and selective approach to global equities is appropriate. We favor parts of the market that can benefit from some of the inflections we are already beginning to see in inflation, Europe’s improving energy situation, and China’s reopening.

This supports our preference for emerging markets, and our preference for Germany and consumer stocks in Europe. Within defensives, we like consumer staples over healthcare, which we downgraded this month. And we continue to favor value and quality income over growth, supporting our preference for energy and the UK over the US market.