Stock market monitor

Q3 2022 equity market outlook from BlackRock Fundamental Equities

Seeking opportunity amid volatility. Global central banks are battling with inflation, and one consequence of their policies is slowing economic growth. How should investors wrestle with the prospect of recession? We outline the areas of the stock market where we believe caution is warranted – and highlight where we see long-term opportunities.

Our outlook:

• We are cautious on technology and consumer stocks amid the shift to a new economic regime.
• We see opportunities in financials as rates rise, and industrials as long-term capex spending booms.
• Supply chain security concerns are leading to long-term investment opportunities.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. The views expressed do not constitute investment or any other advice and are subject to change.

The COVID-19 pandemic ground much of the global economy to a halt. Central banks lowered interest rates and bought greater amounts of government bonds – printing money – allowing governments to support households and businesses. This stoked demand at a time when supply chains were disrupted, creating inflation. Much of this money ended up in the equity markets, boosting valuations. To tame inflation, central banks are draining this excess money supply by raising interest rates and reducing their purchases of government bonds. This "quantitative tightening” may have only just begun, so we see elevated asset price volatility for the rest of the year. European stock valuations have already fallen below historical averages. But in the U.S. – where money supply increased 43% between 2019 and 2021 – stocks still appear expensive on a historical basis.

A sector assessment

A period of rising interest rates and higher inflation reverses the trend of the past four decades. The result could be that some of the big sector winners since the great financial crisis might not be market leaders in the new regime.

Areas of caution

Technology: The valuations of many tech companies that don’t make a profit have plummeted this year. Higher rates make it harder to borrow or raise money to support loss-making operations, and there is now a sharper focus on cash generation. This could drag down the broader sector. Even some of the more resilient areas in tech this year – such as enterprise software companies – are showing signs of vulnerability as some of their smaller customers limit their spending.

Consumer: The war in Ukraine and sanctions on Russia have disrupted the supply of oil and gas, as well as the trade in key crops. Rising interest rates – and central bank guidance that they may increase further – have pushed up mortgage payments. Consumer spending is slowing across income levels as the costs of food, energy and housing soar. Consumer goods companies may struggle as spending wanes or is redirected to services like travel.

Areas of opportunity

Financials: Higher interest rates benefit banks because they can increase their net interest income (NII) – the difference between revenue from loans and the interest they pay on deposits. This means profit margins at “rate-sensitive” banks – where NII grows more as rates rise – may expand even if growth slows, and they could be able to buy back shares. COVID accelerated the shift to digital banking, allowing some banks to close branches and cut costs. And even as central banks forecast higher rates, banking sector valuations remain low on a historical basis. The chart below shows how European banks are now trading at valuations near those during the 2008 financial crisis.

Energy: There is a renewed emphasis on energy security and energy prices, especially in Europe, which relies on Russia for roughly 40% of its natural gas. We seek to invest in companies that provide innovative solutions to the energy crisis, such as the production of hydrogen that can replace fossil fuels in industrial manufacturing; in the makers of semiconductor manufacturing equipment essential to the shift to electric vehicles; in the insulation and heat-pump manufacturers than can improve the energy efficiency of buildings, and in those companies that are innovating to recycle carbon-intensive materials such as cement.

Industrials: Long-term infrastructure spending linked to the European Union’s €1 trillion “green deal” and the $1 trillion infrastructure package in the U.S. means that many industrial companies have full order books. We believe that a period of weakness may provide an opportunity to pick up these long-term investments at an attractive price. Another driver of capital expenditure is the desire to protect future supply chains after the disruption caused by the pandemic and geopolitical friction.

Spotlight topic: Onshoring and automation

The world has now had three clear reminders of supply chain fragility: first the U.S.-China trade wars of 2018, then the pandemic and most recently the war in Ukraine. As a result, there is increased interest among companies in “onshoring,” where production is brought back to the country where goods are primarily sold, or “nearshoring,” where production is brought closer to the prime market – perhaps Mexico for the U.S., or Eastern Europe for the European west. This trend is in early stages, and there is a realisation that it will require significant investment in new factories and local workforces. As labour costs rise - and are a stickier element of inflation - automation becomes a larger draw across businesses.

In 2021, 486,700 industrial robots were installed globally, 27% more than the year before, according to the International Federation of Robotics in June.

Please click here to access the full report: Stock Market Monitor Q3 2022.PDF