In our global tactical asset allocation, we are downgrading global equities to least preferred and are upgrading bonds to most preferred. Volatility in global equities is set to continue, with inflation moderating slower than expected and given the risks around economic growth. In addition, earnings growth should turn negative this year. In this context, fixed income looks appealing to us and offers high carry at lower volatility. The recent performance of non-bank cyclical equities (i.e., information technology) signals only a modest downgrade to growth expectations. Defensive sectors with resilient balance sheets and profitability should be favored for now.
Most important, investors who are already well diversified should refrain from making rash decisions, keep sight of long-term financial goals, and consider opportunity costs and reinvestment risks alongside market risks. History has taught us that for well-diversified investors, the greatest threat to real wealth tends not to come from being invested through periods of short-term volatility, but from being under-invested over the long term.
Risks around EPS are still skewed to the downside
We expect earnings growth for global equities to contract this year. The consequences of restrictive monetary policy for the economy and corporate profits are not well reflected in consensus forecasts, in our view. Consensus remains for earnings growth in 2023, but we think a contraction is more likely. Companies are facing a challenging combination of weakening demand, rising labor costs, and unfavorable comparisons with 2021–22 earnings numbers. Meanwhile, leading indicators, such as new orders, continue to point downward. Earnings momentum remains negative, and earnings downgrades continue to outpace upgrades.
Equity valuations remain unattractive relative to high grade bonds
The MSCI ACWI price-to-earnings (P/E) multiple has corrected from a post-pandemic high of about 20x to 15.0x, above the long-term average of 14.5x. The MSCI US index valuation is at 17.7x, a 10% premium to the 20-year average (16x) and an 18% premium to the global benchmark. We see scope for some further valuation compression in the US should growth disappoint or inflation stay sticky.
Relative to high grade or government bonds, we think global equities are not attractive yet. The equity risk premium (ERP) is falling, and the cost of equity remains consistent with future negative returns versus high-quality sovereign bonds. The actual ERP, as calculated by our dividend discount model (DDM), is at 4.7%, in line with the long-run average. But the earnings yield gap (measured as the difference between the inverted P/E and the 10-year bond yield) is now at a 10-year low and below the long-term average, suggesting that equities are less attractive than government bonds.
We keep the US at least preferred
The US equity market remains expensive in absolute and relative terms. The S&P 500 forward P/E multiple has dropped from 21x at the start of 2022 (when real rates were negative) to 17.7x today (real rates are now positive). However, in the past few months, the relationship has dislocated—equity valuations have declined from their recent peak but still trade above the level implied by the recent relationship with real rates.
Earnings growth is expected to contract in the US in 2023. The headwinds are well known: Aggressive Fed rate increases to slow the economy and reduce inflation; a normalization in demand for products and services (especially tech); and (still) higher-than-average cost increases (mostly for labor). Many of these headwinds are reflected in the generally cautious business sentiment readings for manufacturing and consumer-oriented companies but are not fully reflected in earnings forecasts for the rest of the year and in current valuations, in our view. Many of the key leading indicators such as the Fed's Senior Loan Officer Opinion Survey are suggesting an earnings contraction is likely. In addition, the lagged effects of rate hikes will likely keep the ISM Manufacturing index in the high 40s (anything below 50 denotes contraction) for some time.
UK is downgraded to neutral
We have been positive on UK since April last year. The MSCI UK index has outperformed the MSCI AC World index by 13% over the last year and by 7% since we have been positive on this market. While the UK market remains the most attractively valued across developed markets, the recent drop in energy prices—energy contributes around 25% of the UK earnings—and the expectation of a weaker dollar—the UK generates close to 75% of its revenues abroad—increase the risk for earnings.
This month, we have cut our UK earnings forecasts and now expect 2023 earnings to contract by 7% versus 5% previously. We are therefore downgrading the UK to neutral in our global portfolio.
Read the full report for more in CIO's views on global equities and individual sectors: A defensive tilt is warranted 23 March 2023.
Main contributor: Claudia Panseri
This content is a product of the UBS Chief Investment Office.
