As of 2 December the FTSE 100 index had increased in value by 2.32 per cent year-to-date, or nearer to 4 per cent when cash returns are taken on board. That may appear somewhat anaemic in view of the inflation rate, but it’s certainly one of the better outcomes among the major national indices.
The reason behind this relative outperformance has been well documented and it’s essentially that the UK benchmark is seen as an ‘old world’ index with the heaviest weightings given over to constituents from mature lower-growth industries – ie, those that don’t suck in hefty capital flows in expectation (hope?) of stellar growth rates. It has attracted no end of criticism on this basis, yet it could be argued that the lofty valuation multiples ascribed to many growth stocks were only made possible through accommodative monetary policy. Those with strict monetarist principles would doubtless opine that a reckoning was long overdue.
You need only look at the contrasting fortunes of the tech-focused Nasdaq Composite index to appreciate the impact that the rotation out of growth stocks has had on markets. And it’s possible that another leg-down is in the offing, at least judging by the index’s inflation-adjusted average price/earnings ratio – there’s more room to fall.
There are undoubtedly stocks that have been overly marked down as part of a wider index sell-off, although it will be more difficult to assess valuations based on future cash flows simply because discount rates will probably become more unpredictable. Nevertheless, seasoned stockpickers and contrarian investors will view the current state-of-play as an opportunity to add quality stocks ahead of the eventual revival. The near-term outlook may be grim, but if history tells us anything, it’s that eventually even passive strategies will begin to outstrip inflationary effects through capital appreciation.
On that last point, I would wager that many passive strategies designed to claw back value lost through inflationary effects will centre on the emerging market growth narrative, even though it is looking a little frayed around the edges. The MSCI Emerging Markets index is down by 19.9 per cent through 2022, against a 10.5 per cent fall for the MSCI World equivalent.
This disparity can partly be laid at the door of US dollar strength. The greenback has appreciated against a range of currencies through 2022 as the US Federal Reserve cranked up interest rates in a bid to tame runaway inflation. When emerging market currencies weaken against the dollar it becomes more expensive to service existing dollar-denominated debt payments and it has also precipitated capital outflows in the past. These factors have played out to a certain extent through the year, although the bearish take on emerging markets has as much to do with China’s self-inflicted wounds as it does with borrowing costs.
It can be shown that emerging markets have recovered from previous cyclical downturns before their US and European counterparts. This time around the recovery could be set in motion by declining rates and a weakening dollar, although it’s to be hoped that Beijing’s recent relaxation of Covid-19 restrictions was more than a sop to protestors and the western media. The heavy-handed nature of China’s pandemic response has weighed heavily on the country’s economic output. A more pragmatic approach to the issue would boost internal economic activity.
Unfortunately, export markets are unlikely to provide much support. The country’s geopolitical relationship with the west presents another potential stumbling block, as demonstrated by recent comments by Rishi Sunak pointing to the end of the so-called 'golden era' of relations with China. What this means in practical terms is anyone’s guess.
Yet any signs of an economic reopening in China and a reduced emphasis on achieving zero-Covid would help to trigger an overall emerging markets recovery. The average forward price/earnings ratio for constituents of the MSCI China index now stands at a multiple of 8.2, against 11.5 for MSCI Emerging Markets. The discount is understandable when you consider the ongoing slump in the Caixin services PMI, together with continued anxieties over the country’s stretched real estate sector, although Chinese authorities recently unveiled a “16-point plan” designed to ease financial burdens within the beleaguered housing market.
Wealth preservation, as much as wealth accumulation, has been prioritised though the year as the inflationary surge left the world’s leading economies with their lowest real interest rates in decades. As things stand, volatility will remain the hallmark of western stock indices through 2023 as their underlying economies stagnate. However, logic dictates that emerging markets should outperform once the US Federal Reserve loosens its grip, and the dollar loses its lustre.
