October 2023 Active Management Insights: Higher-for-longer interest rates a chief concern

Executive summary:

The expectation that interest rates will remain at high levels for longer than anticipated is leading equity managers across the globe to favour companies with strong balance sheets. Conversely, managers are more cautious on companies reliant on loans or requiring financing.
Managers remain divided on China equities, but valuations are attractive relative to history and the broader emerging markets opportunity set. Managers are cautiously re-engaging on China through idiosyncratic bottom-up ideas.
Anti-obesity GLP-1 drugs have emerged as a significant investment theme this year, propelling the pharma companies developing these products to significant gains year-to-date. U.S. companies viewed as on the wrong side of this trend within medical devices and food products have underperformed. Some managers believe current valuations among these companies reflect overly pessimistic forecasts, and are beginning to initiate or increase positions.

The third quarter saw an end to the strong run in equity markets, with markets posting their first negative quarter in 12 months on concerns over the longevity of the higher interest rate environment.

Investors now anticipate that most central banks will need to hold rates at higher levels for a longer period of time than previously anticipated, as inflation remains above target levels in most developed economies. This adjustment in rate expectations sparked a renewal in negative sentiment during the third quarter. In addition, oil prices are expected to remain elevated in the wake of OPEC+ countries’ agreement to extend production cuts until the end of 2024, while the ongoing war between Russian and Ukraine and uncertainty in the Middle East following Hamas’ attack on Israel are also continuing to put pressure on inflation and broader investor sentiment.

Amid this uncertain backdrop, we believe that the views of specialist managers are critical to exploiting both risk and opportunity. Drawing on our unique relationship with underlying managers, we’ve compiled the latest insights from specialists across the manager universe into an easy-to-read report. Listed below are the broad overall trends from equity managers heading into the final months of the year, followed by the main tactical observations from key equity and geographic regions across the globe.

Broad global trends

Higher-for-longer interest rates

This is particularly an issue in developed markets, which has impacted longer duration investments. There are also increasing concerns around companies dependent on discretionary spend, given the knock in consumer confidence.
Managers continue to favour companies with strong balance sheets and those able to self-fund investments, while being more cautious on those reliant on loans and/or requiring refinancing.

Commodities tailwinds

Managers globally remain positive on commodities with ongoing allocation.
This is supported by a combination of structural demand. For example, metals such as copper are critical in the transition to clean energy, whereas cement and iron ore are benefitting from the onshoring of supply chains, which require infrastructure investments.
At the same time, supply constraints are providing structural support for commodity prices.

Higher energy prices for longer

Managers continue to favour energy on the back of expected higher-for-longer oil prices. This is supported by the lack of investments in the industry, production cuts from key OPEC+ members (Russia and Saudi Arabia) and growing uncertainty on the back of potential instability in the Middle East as a result of Hamas’ attack on Israel.

China sentiment

There has been a meaningful reduction in global funds’ China exposure and while managers remain divided, valuations are attractive relative to history and the broader emerging markets opportunity set. Managers are cautiously re-engaging on China through idiosyncratic bottom-up ideas.
There are also positive green shoots, with fundamentals being rewarded, particularly in the consumer sector. In addition, continued government support for the real estate sector has been well received.

Positive macro and governance reforms in Japan

Investors have continued to add exposure on the back of positive sentiment driven by reforms, recovery in the economy and changes to consumer behaviour.

Highly disruptive drug innovation

Anti-obesity GLP-1 drugs have emerged as a significant investment theme this year, propelling the pharma companies with GLP-1 drugs to significant gains. Markets have penalised companies seen on the wrong side of this trend within medical devices and food products, which some investors believe has been overdone.

Australian equities

Earnings growth challenged in 2024

Managers expect that company earnings will be under pressure next year. Higher input costs – both labour and goods – plus higher interest costs while demand declines due to a slowing economy are expected to materially squeeze margins for many companies.
Many managers are favouring businesses which have structural growth, the ability to maintain margins and strong balance sheets.

Keeping up the energy

Despite the sector’s outperformance in the quarter, managers continue to hold their overweights in selective energy producers.
Their reasoning is that the underinvestment in oil and gas capital expenditures over the past 10 years will lead to undersupply. Recent capex is significantly less than when oil was last at current prices. Meanwhile, the demand for oil and gas is expected to remain strong in future.
Geopolitical instability is likely to further support Australian energy producers.

Canadian equities

Continuing opportunity in energy

After a strong quarter, equity investors continue to be bullish on energy stocks, but are focused on energy production over infrastructure. Current supply-demand dynamics are favourable, and managers are also considering energy as a risk-hedge to the conflict in the Middle East.

Mixed views across materials sector

Copper companies are seen as the most attractive segment, with energy transition a key long-term secular driver. Gold-mining stocks are also seen as having compelling fundamentals and helping hedge for inflation, but investors are highly sensitive to the location of assets and potential political risk.

Financials are unattractive

Managers continue to be wary of the Canadian banking sector. Banks are facing considerable headwinds from slowing loan growth as loan losses trend higher. Also, while banks’ price-to-earnings (P/E) ratios are at the low end of their historical range, their current earnings yields are not attractive compared to bond yields, given the context of higher interest rates.

High dividend yield stocks are likely to languish

In addition to banks, other companies and industries that offer high dividend income, such as utilities and energy infrastructure, are expected to struggle since bond yields offer compelling income opportunities with lower risk.

Emerging markets equities

Has China bottomed out?

While managers are divided on China opportunities with macro concerns and uncertain timing around improvements, valuations are attractive versus history and the broad equity opportunity set.
The Chinese government has increasingly introduced easing measures to support the real estate sector, which was a key pain point of negative sentiment. Value managers in particular have been adding selectively to those with stronger balance sheets that are expected to weather the storm and come out stronger.
There have been some positive green shoots with fundamentals starting to be rewarded, particularly within consumer discretionary.

Optimism for Latin America continues

Many economies with high real rates, such as Brazil and Chile, are already on an easing path, which provides a positive backdrop for their economies and equity markets.
Many of these countries also benefit from a positive commodity cycle, which is largely a common view among investors.
Although Brazilian equities saw a weak quarter due to potential implications of corporate tax reforms and a re-uptick in inflation, EM (emerging markets) managers remain positive and continue to allocate to opportunities across the broad Brazilian market.

India structurally attractive but expensive

The long-term structural growth case for India continues to improve with China decoupling, leading companies to increase India capital expenditures and infrastructure spend – both of which are growth drivers for the Indian economy.
In the short-term, however, there are some concerns about valuations leading to trimming of positions.

Managers once again looking at Turkey

After several challenging years when the market was somewhat un-investable, there has been a recent pivot by President Erdogan. Turkey’s central bank’s shift toward more orthodox policy measures has opened up valuation opportunities. Higher rates, currency depreciation, and lifting of restrictions in banking are positive signs.

Europe and UK equities

UK equities steeply discounted

The UK equity market continues to struggle for investor attention, though it is now among the cheapest in the world. Sector exposures and a lack of high growth names are often suggested as the reason for this, but even when these differences are neutralised, the UK’s discount to global equities is approaching 30%.¹

Opportunity in domestically focused companies

Domestic UK stocks have shown particular price weakness relative to exporters. Infrastructure stocks stand to benefit from increased government spending, particularly to support decarbonisation. Many of these small/mid cap stocks trade on low single-digit multiples backed by solid fundamentals, making it a segment which is ripe for consolidation.

A burgeoning case for insurers

The insurance sector is supported by the structural tailwind of excess capital as a result of post-GFC (Global Financial Crisis) prudence, updates to Solvency II regulations and demographic change. On the growth side, pension fund buyouts are increasing following the rise in interest rates, while pension auto-enrolment underpins inflows. Despite these positive fundamentals, valuations across the sector are depressed, with many dividend yields approaching double digits.

Consumer environment favours companies that offer value

A noteworthy shift in consumer behaviour is underway, as individuals increasingly prioritise value and essentials over discretionary spending. While European excess pandemic-related savings initially masked this trend, recent bottom-up evidence reveals its impact on companies' demand dynamics and product mix. Businesses catering to cost-conscious consumers, particularly at lower price points, are poised to benefit as this paradigm shift gains momentum.

Global equities

Asymmetrically attractive European value opportunities

Value investors are further adding to European financials on attractive valuations while staying risk-aware, focusing on lenders that are well capitalised, with high net interest margins and asset quality.
Managers see eurozone consumer staples as offering attractive upside/downside rewards, with entry points at depressed valuations in businesses that exhibit resilient cash flows.

Early signs of EVs’ competitive landscape

Clouds are brewing for European autos who are playing catchup to Chinese importers. Deflationary pressure from competitive Chinese EV (electric vehicle) producers potentially weakens their earnings outlook.

Commodities are becoming strategically defensive

Growth and value investors are increasing their exposure to metals such as copper and aluminium – which are seen increasingly as resilient due to continual structural demand, and benefit from tightening supply reduction.

Drug innovation is highly disruptive

Recent successes of diabetes drugs for appetite-suppression and weight-loss are inadvertently tackling obesity and related illnesses. The outlook for specific drug providers surged while insulin competitors derated. This could also impact food and beverage companies around consumer habits and reduced sugar intake.

Adding to Japan in wake of macro and governance reforms

Investors are adding to Japan exposure in anticipation of more hawkish Bank of Japan (BoJ) policy. Key beneficiaries of a higher interest rate environment are Japanese banks. Exporters will also benefit in potential yen depreciation relative to the U.S. dollar.

Sentiment swings back toward growth

Managers are readjusting to the economic growth implications of persistent and higher interest rate levels. Derated growth stocks have presented opportunities for managers to add to positions on weakness.

Japan equities

Managers increasingly positive on Japan equities

The Japanese economy is in a relatively good shape, benefitting from the ongoing recovery in tourism, an expected increase in capital expenditures driven by replacement demand, additional investments in energy efficiency, improved labor productivity, and production shifts to Japan.
Improvements in governance are expected to lead to continued rerating for low price-to-book (PB) stocks. These tend to be old economy businesses such as banks or trading companies. which are also beneficiaries from an inflationary environment. Many investors have maintained a positive view on the sectors while taking some profits.
Possible asset allocation shifts to equities are being triggered by the introduction of the new NISA (tax-exempt savings account) scheduled in 2024, with a raised and permanent tax-free allowance.

Long/short equity

Rising optimism in Japan

Deflation to inflation transition: The early signs of transitioning from a deflationary to a modest inflationary mindset in Japan signify a potential substantial impact on consumption and investment attitudes.
Corporate governance renaissance: A decade of corporate governance reforms is ushering in genuine improvements in governance, capital allocation, and shareholder returns, with a majority of companies yet to adapt – indicating a vast reservoir of unlocked value.

Dynamics in China

There was a sharp reduction in gross exposure to China by global and pan-Asia equity long/short managers in the first half of 2023 due to macroeconomic and political uncertainties.
Recent trends show cautious re-engagement, exploring idiosyncratic long ideas and incrementally adding shorts – albeit facing a narrow and costly short universe, mainly within mega-cap companies.

Rekindled interest in equity long/short (L/S) strategies

In the wake of the Q3 2022 market trough, 2023 has witnessed a resurgence in investor interest for L/S strategies, with a tilt toward low-net and market-neutral L/S strategies.

U.S. equities

Time for small caps?

Through the end of the third quarter, U.S. small cap stocks have underperformed their large cap counterparts by 10.5% year-to-date – and by more than 40% over the past five years, leaving them at a more than 30% discount to historical averages.
Managers across styles (both value and growth) and approach (fundamental and quant) are emphasising that higher-quality smaller-cap stocks are presenting greater opportunities in recent months, and are selectively adding to positions.

Awaiting the impacts of higher interest rates

Longer-term interest rates increased meaningfully in the third quarter, with yields on 10-year U.S. Treasuries and corporate bonds alike hitting their highest levels in more than 15 years.
Managers are growing increasingly cautious on companies dependent on discretionary consumer spending, believing more restrictive financing terms and reduced affordability will lead to a slowing of demand for housing and autos.
Managers also believe higher interest costs are influencing corporate financing and spending decisions, with more leveraged companies within real estate and even utilities seen as particularly vulnerable to refinancing risks.

Opportunities in healthcare and consumer staples

Although overshadowed by artificial intelligence in the headlines, anti-obesity GLP-1 drugs have emerged as a significant investment theme this year, propelling the pharma companies developing these products to significant gains year-to-date.
Companies seen as on the wrong side of this trend within medical devices and food products have underperformed. Some managers believe current valuations among these companies reflect overly pessimistic forecasts, and are beginning to initiate or increase positions.

¹ Source: MSCI, IBES, Morgan Stanley Research (sector neutral - avg of PE, PB, PDiv).

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.