Some fund managers are optimistic that a recession has already been priced into stock markets.
It has been a challenging year for investors to make money, reflected by the fact that equities and bonds have unusually fallen in unison.
The question going forwards is whether the bear market has further to run, particularly as the UK is set to enter a recession early next year. The downturn is expected to be shallow but prolonged, and it is expected to last until the second half of 2024.
Some fund managers argue that a recession has already been priced into stock markets – particularly more domestically focused UK mid and small-cap companies, which have seen some severe slumps in their share prices in 2022.
In addition, there’s a growing consensus that inflation is at or near a peak. Therefore, it is expected that the pace of monetary tightening, in the form of higher interest rates, will soon slow.
Clive Beagles and James Lowen, fund managers of JOHCM UK Equity Income, point out that in November many stocks and sectors that have meaningfully underperformed over the past six months have staged a recovery “as fears about central banks over-tightening to combat short-term inflation somewhat dissipated”.
The duo said: “Retailers such as DFS Furniture (LSE:DFS) and Currys (LSE:CURY) outperformed by more than 10% (in November). They were helped by the fact that many UK consumer-facing companies reported that trading had slightly strengthened over the last two months, in contrast to perceptions that it would have weakened. These companies included Fuller Smith & Turner (LSE:FSTA), Kingfisher (LSE:KGF), Topps Tiles (LSE:TPT) and ScS Group (LSE:SCS).
“Elsewhere, among the somewhat cyclically exposed sectors, both advertising-exposed stocks, such as ITV (LSE:ITV) and WPP (LSE:WPP), and recruitment agencies PageGroup (LSE:PAGE) and SThree (LSE:STEM), all outperformed by more than 5%.”
The duo argue that markets are “entering the final furlong of monetary tightening and events in November reinforced that view”.
They added that: “Underlying inflationary pressures are already showing signs of deceleration in many parts of the world. This situation will be accentuated in February next year once we annualise against the energy price spike following the invasion of Ukraine.”
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Ian Lance, co-manager of Temple Bar (LSE:TMPL) investment trust, agrees that certain parts of the UK equity market have already priced in a recession.
Appearing in our latest On The Money podcast, Lance says: “I think [a recession] is already being priced into the market. If you look at the performance of different sectors year-to-date, the best-performing sectors are the most defensive ones, things like tobacco and consumer staples.
“The worst-performing sectors year-to-date are autos, housebuilders, and retailers. Some of those sectors have halved year-to-date. This certainly suggests that a recession is being priced in.”
Against that, a big risk that could de-rail markets in 2023 is if future earnings expectations for companies are looking too optimistic. The pros that are more cautious, including Duncan MacInnes, fund manager of Ruffer Investment Company (LSE:RICA), make the point that stock market declines this year have priced in interest rate rises, but not future downgrades in earnings.
MacInnes thinks earnings forecasts heading into a recession are too optimistic, and will be cut. In response, the market will likely take a dim view of this, which in turn will extend the bear market in 2023.
Lance acknowledges that earnings downgrades could happen, but his view is that the market tends to overreact on near-term earnings movements.
As a value investor, Lance said he would use this as an opportunity to buy shares at a cheaper price. He makes the point that “a change in earnings over one or two years does not change the long-term value of a business”.
Other reasons to be cheerful
When focusing on the micro rather than the macro “there’s a big disconnect between the underlying performance of a company and their share price performance this year”, points out Chris McVey, fund manager of FP Octopus UK Multi Cap Income.
He adds: “What’s exciting me most at the moment is the fact that companies are delivering operationally, but their valuations and share prices have been de-rated.
“UK mid-cap and small-cap stocks have been de-rated to levels only seen five times in the last 30 years, with earnings downside risk being priced in.”
Neil Hermon, fund manager of Henderson Smaller Companies Investment Trust (LSE:HSL), one of interactive investor’s Super 60 investment ideas, is also positive about the micro outlook for UK smaller companies.
In a recent video interview with interactive investor, Hermon said: “Although things have become more difficult (in 2022), earnings growth has still been very robust. So the portfolio is growing its earnings by around 19% this year and forecast 10% next year.
“In some ways, we've already had the underperformance. So, markets move ahead of the reality, with mid and small-cap down 20% this year, reflects what they think about the future. So we've already had that underperformance already in place and that provides an opportunity going forward.”
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Ken Wotton, fund manager of Strategic Equity Capital (LSE:SEC), finds reasons for optimism in the “agility and niche positioning of many smaller companies”, which he says “can allow them to navigate more smoothly through economic headwinds”.
He adds: “The heightened uncertainty witnessed this year has meant many British small-caps are trading at considerable discounts compared to their large-cap peers. Investors able to buy now can set themselves on a solid footing to generate strong returns moving forward.”
Wotton also says that lower valuations and a weaker UK pound have also made UK small-caps more compelling for foreign investors.
The case for defensive firms
Chris Elliott, co-manager of the TB Evenlode Global Equity fund, is encouraged by the prospects for resilient stocks, such as luxury goods. He points out: "Consumers of luxury products have high disposable incomes and are less sensitive to economic shocks.
“We hold positions in the French luxury goods designers LVMH (EURONEXT:MC) and Hermes International (EURONEXT:RMS). Both demonstrated their resilience during the global financial crisis, with LVMH revenues declining by less than 1% in 2009 and Hermès growing throughout the crisis.
“A recent Redburn survey of luxury customers supports continued consumer spending, with only 9% of luxury consumers intending to shop less in 2023. Over the past year, these luxury businesses demonstrated their brand strength and pricing power, with double-digit price increases passing input cost inflation through to consumers.”
And finally, Phil Collins, chief investment officer for multi-asset at Sarasin & Partners, says he is feeling optimistic that “we might have finally dropped off inflation’s summit and the bulk of the interest rate hikes and their accompanying market volatility could also be behind us”.
Collins added: “Yes, we expect to see recessions in the US, UK and Europe, but these could be mild. Lastly, investor sentiment is as low as it has ever been, and a great deal of bad news has already been priced into equities.”
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