Investor risk appetite is returning: here’s where to look for value

Morningstar’s latest monthly article points out that despite many headwinds, investors are taking a more positive stance on the outlook for markets.  

As we highlighted in our market overview article for the Super 60 and ACE 40 lists at the start of the year, 2022 was an extraordinary year for financial markets. We witnessed dramatic changes in geopolitics, the global economy and fiscal and monetary policies, which resulted in investors having to deal with numerous shocks and wild changes in the outlook across the investment landscape.

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While Russia’s invasion of Ukraine continues to impact the outlook for markets, there is little doubt that the outlook has brightened somewhat resulting in improved sentiment towards riskier assets. There is an increasing feeling that the worst may be over from an inflation and interest rate perspective, which continues to propel markets higher.

Bull market winners knocked off their perch

Throughout 2022, some laggard asset classes of the previous few years actually outperformed the previous winners, which is interesting and perhaps gives investors a glimpse of the future for 2023 and beyond. It is often the case when economies and markets go into a downturn and begin to recover that the previous darlings that led the bull market fail to keep up with the next market cycle. 

We have an interesting example of this with the TMT boom and bust in the late 1990s and early 2000s, where the technology and telecom stocks that had powered the bubble de-rated dramatically and rarely recovered. The prices of Nokia (NYSE:NOK) and Vodafone Group (LSE:VOD) are instructive examples of this phenomenon as they remain close to where they were 20 years ago.

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Investors are now beginning to focus on what the world will look like on the other side of the first half of 2023’s almost inevitable recession, and indeed how deep that recession will be.

Better news on the energy supply front due to heavy stockpiling and warmer weather over the European winter, less pressure on central bank tightening and the rapid opening up of the Chinese economy as lockdown restrictions are removed, mean there is potentially light at the end of this particularly unpleasant tunnel.

Risk appetite is returning  

What can we expect to see during 2023 as we get closer to the end of the recession or feelings of recession? With the obvious caveat that Russia’s invasion of Ukraine still poses considerable risks and uncertainty to the outlook, it does appear that the recession this year will be relatively mild and short. In fact, certain regions globally may avoid recession altogether.

It is therefore no surprise that investors’ risk appetite is returning. Riskier assets are beginning to garner interest from investors and, interestingly, the laggards of the last few years are showing relative outperformance.

The best example of this is the UK equity market, which produced great relative performance during 2022 despite weak economic numbers, political chaos and continued negativity around Brexit’s effects. 

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The riskier elements of fixed income also performed better than less risky assets such as government bonds. While we will almost certainly see the recessionary impact on corporate earnings and credit defaults in certain regions and assets, it is also a reasonable assumption that the market may look through this and assume that the latter part of 2023 will look brighter.

Where investors can find value opportunities

Looking at valuations, wider industry trends and where investor interest may be focused, we may see somewhat of a barbell type of leadership through the year.

For example, smaller companies are on lower valuations, as investors shunned them as being most exposed to the worst of the pandemic and may now offer better upside. Similarly, the UK and European equity markets, in particular Germany, continue to look attractive from a valuation perspective. 

In contrast, some sectors could be on the cusp of a prolonged boom due to structural changes. For example, it would be unsurprising if we saw defence expenditure continue to rise globally with this tailwind of demand helping defence manufacturing companies.

Similarly, the health and pharmaceutical sectors are also beginning to reap the benefits of decades of investment in genomics with new ground-breaking drugs potentially positively impacting those companies’ earnings. 

In contrast the leaders of the past five years, most notably technology companies are still weighed down by high relative valuations, slowing earnings and increased pessimism around the impact of new regulations.

In summary, it is a reasonable assumption that the economic clouds will brighten over the course of this year and risk assets may end higher than they started. In the intervening period the short-term impacts on markets of the recession may buffet performance and increase volatility, but the leaders of the past may not be the best place to be invested.

Gavin Corr is head of due diligence and manager selection,Morningstar Investment Management Europe.