Investors should not expect everything to go ‘back to normal’ in 2023, says Melda Mergen. Higher inflation and a weaker economic environment will mean not all companies will thrive.
As the economy reopened after the Covid-19 pandemic, we saw a
lot of one-off drivers of inflation, but longer-lasting drivers have also
been unleashed. So, we are now seeing changes in supply chains –
companies reshoring and building out new networks – and geopolitics,
and these don’t resolve quickly. I do expect inflation to fall, but not
back to pre-pandemic levels. When a dislocation like this happens you
never go back to where you started, and where we end up is one of
the key questions for 2023.
Inflation generally means equity valuations come down, and we
saw that through 2022, but on a broad market basis. I think that
we will see greater dispersion in terms of valuation in 2023, with
longer duration equity – companies with growth expectations
farther out in the future – suffering more. Investors will have
to be more careful about what they are willing to pay for future
earnings, and demands for profitability will come sooner. All of
this will mean that companies that aren’t able to deliver earnings
are more likely to see the market take down their valuation.
Cash on hand will matter
Many investors think of valuation in terms of price-to-earnings
(P/E) multiples, and although that metric is useful it is not the
only measure of a company’s value. I think free cash flow will be
more important as a metric because it will be a good indicator
of how resilient a company may be in a weaker economic
environment and while inflation is running higher. Cash on hand
can also help deliver stock buybacks, which can support a
company’s stock price. It will be a lot more expensive to fund
buybacks through debt so free cashflow and dividend growth
(rather than the absolute level of yield) are both metrics that may
indicate a higher quality company.
Relative opportunities, resilient companies
While economic growth is slowing, at this point it doesn’t
look like a recession in the US will be very deep. In contrast,
economies in Europe are under significant stress and a deeper recession there seems likely. In emerging markets, we have
seen economies under stress from China’s zero-Covid policies,
the strong US dollar and geopolitics.
In thinking about global opportunities, at a high level the US is
more attractive than other regions. I also think that small caps
may offer greater opportunity than large caps, especially since
larger companies tend to have greater non-US revenue exposure,
with around 35% of revenue outside the US. I also still think that
a tilt towards value over growth makes sense. There are certain
value areas – industrials or energy, for example – that will
still be benefiting in 2023. That said, growth is becoming
more interesting. Many growth companies underperformed
in 2022. However, we know their business models are not
broken, we know they still have competitive advantage.
But because interest rates rose in 2022, the valuation of these
companies came down, there was a significant rerating. If
you believe that is now done, then I think growth will be very
interesting too.
However, either way you will need to go deeper than big
picture observations to succeed in 2023, meaning an active,
company-by-company approach. Passive indexes, especially
in international markets, can have embedded concentrations
that can hurt portfolio performance. To succeed in 2023 you
will really need to distinguish between companies that are
more resilient and those that aren’t.
