After the fall: equities and bonds
For the first time in several years, we have a more constructive view on government and corporate bonds. We remain slightly more cautious on equities, but are looking for opportunities to add to our allocation.
After a significant reset in valuations across both equity and bond markets, we have been assessing whether to take advantage of market weakness and rebuild our exposure. For now, we are more comfortable adding to fixed income. We anticipate that there will be better opportunities to add to equities over the coming months.
Markets may be too optimistic on earnings in 2023
The peak to trough decline in S&P 500 earnings per share during recessions
Past performance is not an indicator of future returns and may not be repeated
Source: Refinitiv Datastream, Schroders
Key for both asset classes is the outlook for inflation and interest rates – especially in the US. We may well have seen the peak in US inflation, but year-on-year readings remain high and the Federal Reserve will want to see further evidence of a more persistent downtrend before changing the direction of policy. Historically, more persistent cooling of inflation has required a weaker labour market. We have not seen this yet.
We’re more positive on fixed income...
Our long-running underweight position in fixed income has, at times, been a source of discomfort. However, our persistence paid off in 2022, when bond markets experienced their worst sell-off in decades. Over the last quarter, we have been increasing our exposure to government bonds as valuations have improved and the risk of recession has increased. We are moving gradually, reflecting the fact that bond market volatility could persist as rates continue to rise over the coming months.
To manage our interest rate risk, we prefer shorter maturity bonds which are less sensitive to interest rate changes. Once it becomes clearer that interest rates are at or near a peak, there may well be an opportunity to increase our exposure to longer maturity bonds. These would benefit more if central banks signal they are looking to cut rates to support growth.
...but not quite there on equities
We expect that developed market economies – including the US and UK – will fall into a recession in 2023. Economic activity indicators are therefore likely to decline in the near term. Our view is that we are unlikely to see a more sustained equity market recovery until the negative momentum in economic data slows.
We also want to see signs that earnings expectations have bottomed. Historically, when the US economy has contracted, earnings have on average fallen by 14%. Analysts have lowered their earnings estimates for next year by just 4%. This looks too optimistic in an environment of high inflation and slowing economic growth.
Valuations provide a more compelling case for adding to equities. US equities trade at a slightly higher valuation than the average over the past 15 years, but in all other regions shares are generally cheaper than average – in some cases significantly so. Globally, equity markets therefore look far better value today than they did at the start of 2022. While we are definitely getting closer, our signals are not yet flashing the all clear for equities.