Industry Voice: A turning point for global equity markets?

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Jamie Harvey, Portfolio Manager, Fidelity Sustainable Global Equity Fund

Jamie Harvey, Portfolio Manager, Fidelity Sustainable Global Equity Fund

We believe global equity markets are facing up to a number of crucial turning points, with several powerful trends that have driven markets over the last two decades seemingly at an inflection point. This will have significant implications for future market leadership.

Interest rates, which have been on the decline for the nearly four decades, have increased sharply as central banks have sought to rein in surging inflation over 2022. Lower rates had cut the cost of capital driving valuations higher, particularly those of growth stocks. Meanwhile, the US dollar has recently fallen from its 20-year high as signs of inflation easing have fuelled speculation that the Fed will have to pause its rate hikes.

This backdrop has already driven a dramatic change in markets with high-growth tech stocks selling off. Value stocks and sectors have started to outperform, and this could mark the start of a more sustained shift in market leadership over the coming years.

Where next for valuations and earnings?

The Fed's aggressive rate hiking cycle and quantitative tightening has led to a huge withdrawal of liquidity from the system, leading to lower asset prices. Equity valuations are currently back to pre-pandemic levels in the US, but are still slightly expensive compared to history, and close to long-term averages elsewhere.

Valuations are normalising

Source: Fidelity International, Bloomberg, 31 December 2022. The long-term P/E ratio chart shows regional equity markets relative valuation comparison across multiple business cycles with latest twelve-month forward price/earnings consensus estimates.

The next leg of the story for equity markets is likely to be driven by earnings. After a period of above-trend earnings growth and profit margins, we think an earnings correction is likely in 2023. We are already seeing some classic early signs. For example, companies have started to guide more conservatively; we are starting to see profit warnings among some early-cycle industries like consumer discretionary and there are a growing number of layoff announcements. These are clear signs that companies are starting to feel the pressure on profit margins.

A 20% correction would be in line with previous earnings downcycles observed over the last 50 years and would see earnings fall back to long-term trend-growth. This seems like a reasonable base-case scenario to us. The good news is this correction started last year and as more visibility emerges on the likely path of earnings over the coming months, we expect equity markets to look ahead to a resumption of growth in 2024.

Earnings drawdown coming

Source: Citi Research Global Equity Strategy, DataStream, 3 November 2022. The recreated chart shows the past 50-year global equities EPS data trend during the last 7 recessionary periods.

A watershed moment for sustainability

In an unpredictable world, the big question for investors is where can they find more certainty in where they should invest? We believe that sustainable stocks provide this certainty and visibility as they address some of the biggest challenges we face as a global society - issues that need to be fixed, regardless of the short-term market outlook.

Our strong belief is that companies addressing some of our greatest environmental and social challenges will enjoy strong demand growth for their products and services and stand to earn higher and more durable returns over time as a result. By being on the right side of policymakers and regulators they are also likely to enjoy lower long-term risk profiles. These companies therefore have the potential to deliver strong returns to shareholders, whilst also being a driving force for positive societal change.

There is no doubt in our minds of the very significant impact that sustainability factors will have on long-term value creation. This can be illustrated by two examples. Firstly, we are all aware of the dramatic rise in global temperatures. This has all sorts of implications, but one very clear investment consequence is the rapid growth in renewable energy deployment as countries decarbonise. The International Energy Agency expects renewable power to surpass coal power generation by 2025 and we will add as much renewable power in the next five years as the last 20. For those companies in the renewables value chain, the growth potential is substantial.

Another example is that of shifting demographics which will have a profound impact on the future. There are more elderly people than young children in the world and by 2050, there will be more than double the number of over-65s compared to under-5s. These demographic changes have huge implications for healthcare - both in terms of overall demand, but also the need for continued innovation.

There are also important implications for resource intensity - in order to feed, house, care for this growing and changing population we will need to do more with less. A falling proportion of working age people will also need more investment in automation and productivity tools as companies look to maintain margins and grow profits.

Certainty in the biggest changes we face

Source: Fidelity International, UN Population Division, 8 April 2019. The recreated chart shows the % of elderly people (65+ years) and young children (under 5s) in the global population. The percentage of over-65s surpassed that of under-fives at the end of 2018.

The elephant in the ESG room

While the long-term case for sustainability is clear, we do need to address some of the headwinds the sector has faced over the last 12 months. Performance for many sustainable funds has been challenging as areas like energy, commodities and defence have outperformed. On top of that, unclear and in some cases overstated ESG credentials have created an "ESG trust deficit", as the FCA recently put it. Many investors are rightly questioning if investment managers are investing in the way they say they are, and whether companies really do deliver the positive impact they say they do.

In our view, these issues primarily stem from the fact that sustainable investing is still developing and leaves much room for individual interpretation. But this will improve with time. Generally accepted standards and norms take time to form. Reputations take time to be built. We don't think this lack of common ground means that we should give up on ESG investing all together. What it does mean is that we must pay close attention to ensure sustainable investors are practicing what they preach.

For some investors, the positive environmental and social impacts these companies may deliver will be key, while for others the attraction will be investing in high-quality, well-run companies with exposure to strongly growing end markets which also happen to be on the right side of regulators and policy makers. Both are valid arguments and that is why we believe sustainable investing is here to stay.

Navigating what happens next in markets

If the current environment of higher inflation, interest rates and economic volatility persists, we could be looking at quite a different decade ahead for market leadership. However, we would emphasise that many long-term global sustainability trends remain unchanged, and in many cases, have been strengthened or accelerated by recent events.

Our process of combining in-depth sustainability and fundamental research with a strict valuation discipline leads us to invest in companies with strong financial profiles, backed by significant cash flow generation in the near term that provides a level of downside protection. We believe this approach will continue to enable us to navigate volatile markets, while also being well placed to capture the exciting long-term growth opportunities ahead of us.

Find out more about the Fidelity Sustainable Global Equity Fund