While much can be said about the drivers of the market rout in 2022 – multidecade-high inflation, rapid rate increases, slowing growth, ongoing COVID-19 lockdowns, and the Russia/Ukraine conflict – remarkably, very little can be said yet about how or when these issues get resolved. Central bank policy hinges on inflation moderating, and it may be another year before we know the impact of rate increases on economic growth. The political backdrop is in flux, with China’s Xi Jinping starting a third term and facing backlash to zero-COVID policies. Meanwhile, the conflict between Ukraine and Russia is approaching its one-year anniversary, with no clear end in sight.

Investors, as a result, may have to brace themselves for more market volatility in 2023. Almost all asset classes declined in 2022, helping improve valuations from a year ago, when multiples sat at abnormally elevated levels. But we hesitate to call the market cheap – at best, large categories such as U.S. equities trade around their historical average. What’s more, companies have started to lower earnings guidance or pull guidance altogether in light of economic headwinds such as a strong U.S. dollar, making U.S. exports competitively disadvantaged. If earnings expectations continue to be adjusted lower, stock prices could have further to fall.

Investment article

Figure 1: Even after declining in 2022, U.S. equity valuations remain elevated

Even then, the biggest issue facing markets in 2023 may be parsing whether today’s challenges are transitory or the first tremors of a seismic shift in the investment paradigm. In our view, a number of structural elements appear to be supporting persistent inflationary pressures. These include greater regulatory intervention (especially around environmental issues), the aging of the workforce, geopolitical uncertainties, supply constraints, climate change, and fiscal policies. Even if peak inflation rolls over soon (if it hasn’t already), investors will have to weigh whether higher inflation generally – and reduced productivity, as a result – will remain dominant themes through 2023 and beyond.

A new investing playbook

In this environment, we think it is risky for investors to continue with the investment playbook of the last decade. In years prior, ultra-loose monetary policy helped to lift all stocks. Now that rates are rapidly rising, we believe investors need to change tack, focusing on companies not dependent on cheap capital to thrive. To find those, we suggest looking for firms that have visible forward earnings and trade at an attractive price relative to the cash they generate. Great companies priced above the market average can continue to work, but they will need to meet already high expectations to perform well – a challenge in a potentially slowing economy. And a lack of forward visibility on cash flows only amplifies uncertainty for investors, which can increase volatility.

Figure 2: Earnings forecasts have been trending down in the second half of 2022 – and could move lower in 2023

Companies with earnings visibility, on the other hand, are less likely to deliver unwelcome surprises. While it’s possible to find examples of these firms across all sectors of the economy, we believe areas such as large-cap pharmaceuticals and biotechnology, materials, energy, and financials provide rich hunting ground for investors. These sectors not only tend to have sizable free cash flows, but they are also inflation and/or rate sensitive and could benefit from some of the structural shifts we see taking place in the economy. For example, copper miners could be well positioned for the green energy transition given years of underinvestment in projects to extract the metal, the main conduit for electricity.

Finding value overseas

These sectors also feature prominently in non-U.S. markets, where valuations look comparatively attractive. To be sure, the lower multiples reflect near-term challenges, including spiraling energy costs and rising rates (Europe) or COVID lockdowns and shifting trade dynamics (China). But these economies tilt more heavily than the U.S. toward the sectors listed above and are home to some multinational firms integral to global supply chains. With low valuations and the benefit of a strong U.S. dollar, we think certain stocks within these regions could be attractive opportunities over a two- to three-year time horizon.

Figure 3: While equity valuations contracted globally in 2022, some regions are more discounted than others

It may take courage to hold the shares, especially when behavioral biases such as herd mentality and risk aversion lead markets to buy or sell without regard to fundamental return potential. But in our experience, those periods often provide some of the best opportunities to acquire great assets at great prices, rewarding disciplined investors.

IMPORTANT INFORMATION

Energy industries can be significantly affected by fluctuations in energy prices and supply and demand of fuels, conservation, the success of exploration projects, and tax and other government regulations.

Financials industries can be significantly affected by extensive government regulation, subject to relatively rapid change due to increasingly blurred distinctions between service segments, and significantly affected by availability and cost of capital funds, changes in interest rates, the rate of corporate and consumer debt defaults, and price competition.

Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.

Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.