We are now in an economic regime quite different from the decade following the global financial crisis
Market leadership began to broaden throughout the third quarter relative to the narrowly led performance we experienced in the first half of the year. We believe that we are now in a different inflation and interest-rate environment – one that we have not seen in a long time – and we expect the broadening of market leadership to continue.
Beginning in June, following stronger-than-expected economic data, the market began to acknowledge that monetary policy was not likely to shift from tightening to easing anytime soon, thus coalescing around a view that rates are likely to remain higher for longer.
This sentiment pressured the valuations of longer-duration cash flows, and we subsequently experienced a shift in style performance to favor value over growth. This was evident during the quarter as the MSCI All Country World Index (ACWI) Value outperformed its growth counterpart by 3.11 percent.
Relative outperformance was driven by inexpensive and cyclical sectors such as energy, autos, financials, and consumer discretionary retail. We have also seen a broadening in regional performance. Italy, Spain, and Japan outperformed in developed markets, while Brazil, India, and Turkey had strong returns in emerging markets.
The global economy remains on an expansionary course, although the pace is slow.
Disinflation has been the primary story over the course of the year. In the United States, inflation has averaged two percent to 2.5 percent since June, but more recently higher energy prices drove inflation toward three percent. Shelter also remains a primary driver of the year-over-year change in the Consumer Price Index (CPI), but shelter prices are sequentially decelerating on a monthly basis. While the monthly data may be volatile, we expect that US inflation will likely remain in the 2.5 percent to three percent range for the remainder of the year. We have seen a similar trend in Europe.
A soft landing is likely.
Importantly, disinflation’s ability to buoy real incomes and consumer spending growth is improving, particularly in developed markets. It has contributed to positive real wage growth in both the United States and Europe. This is contributing to better purchasing power and stronger consumption, which we expect to support gross domestic product (GDP) growth. It also suggests that a soft landing is likely.
We continue to closely monitor energy prices. Although natural gas prices have come down across the board, it is important to note that European gas prices are still twice as high as they were before the Russia-Ukraine war. In particular, Germany has seen a significant hit to its energy-intensive industrial production, primarily due to these higher prices.
Earnings growth expectations
How does this all equate into expectations for corporate earnings growth?
There appears to be a significant amount of mispricing between what we expect in aggregate economic growth and what has been observed in consensus estimates, and we note some interesting divergences.
We believe developed Europe and Japan are likely to have the most potential upside in 2024.
US companies are expected to deliver double-digit earnings per share (EPS) growth next year; however, we believe these estimates could be overly optimistic. Developed Europe, meanwhile, is likely to be one of the weakest regions for corporate earnings growth for the remainder of the year. These markets contrast with Japan, which has experienced strong and broad earnings growth this year, while estimates for next year appear quite modest. We believe developed Europe and Japan are likely to have the most potential upside relative to expectations in 2024.
Emerging markets, led by China, have been the weakest performers this year. Perhaps not surprisingly, estimates are pointing to a rebound in earnings in 2024. While economic activity in China has decelerated throughout the year, recent macro data suggests that the economy is near or at trough levels. Signs of stabilization in the purchasing managers’ index (PMI), acceleration in retail sales growth, and easing of deflationary pressures are encouraging.
Where to from here?
While the prospect of higher-for-longer rates has seemingly surprised the market, we believe we are now in an economic regime that is quite different from the decade following the global financial crisis. That period was anomalous, with low inflation and extraordinarily accommodative monetary policy. We merely expect low inflation and extraordinary accommodative monetary policy to revert to the very long-term averages of previous decades.
Ken McAtamney is partner, head of the global equity team, and portfolio manager at William Blair.