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Earnings Recession and Policy Deterioration

Following solid returns in March, April saw less momentum, but still primarily positive returns across global bonds and equity markets. An exception was the euro bond market where there is still some nervousness about the ECB’s desire to hike rates. One reason for the declining momentum in the equity market is the continued uncertainty about the macro cycle, and its effect on both corporate earnings and risk premiums. Another reason is the ongoing earnings recession and market valuation. With S&P 500 trading on a 12-month forward price earnings ratio of 18 times, it is close to its long-term average and is therefore not giving much guidance on the current attractiveness of equities. Additionally, while the Fed signalled it has most likely ended its tightening, there is still uncertainty about their ability to predict their own actions and risks as to how much effect the already administered tightening will have, let alone what would cause a reversal in rate hikes. In this environment we think it is unusually likely that things either play out very badly or very well for equity markets. On the following pages we will offer our view on why this is the case and what factors we expect will decide the outcome. Starting top down and looking at the global political environment, the situation is complicated to say the least. Recent communication from the French president makes it unnecessarily difficult for both friends and enemies to understand what Europe is wishing for, let alone working for in Ukraine, Africa and in relation to China.

Figure 1: S&P 500 Q1 2023 earnings are declining year on year

For Europeans and Americans alike, Chinese communication seems much friendlier than Chinese actions and from a Chinese perspective, neither the current nor the former US administration appear easy to work with. Broadening the perspective to the Global South, it is not clear to us how it can help the world that Lula, a man previously convicted of corruption, suggests that Putin, representing a country with centuries of tradition of oppressing its neighbours and its own population, should be allowed to invade an independent country and “keep Crimea”. Amid all this confusion, a few things are clear. One is that China no longer has the world’s largest population. This role is now taken over by India where the working age population is growing while the Chinese working age population is shrinking rapidly. This, combined with China’s renewed political controls on society, are the main reasons we expect that trend growth in China will be close to 3-5%. This could look like a negative scenario, but in comparison to Chinese growth in the 500+ years from 1450 to 1980 it is very positive. Returning to the US reporting season, S&P 500 earnings started declining year over year in Q4 2022. With 268 companies having reported Q1 2023 earnings at the end of April, the I/B/E/S data showed earnings running 7.7% above expectations. This unusually high level of positive earnings surprises lifted the expected earnings decline from -6% year on year to -1.9%. Figure 2 shows that the decline is expected to continue into Q2 2023. From H2, we expect earnings to recover and support both equities and high yield bonds. On the following pages we will outline the cyclical risk to this scenario. For now, we remain positioned as follows:

  • In our growth strategies, with up to 100% equities, we hold equity allocations close to maximum levels, with corresponding underweights in high grade bonds. In EDGE Sustainable Growth, these positions are concentrated in the low pollution, high growth sectors, such as IT and Healthcare.

  • In our balanced multi-asset strategies, we hold equity allocations close to maximum levels and maintain significant holdings of high yield bonds. where yields are currently above 7% in Euros and above 7.5% in the USD market.

  • Across our Global Fixed Income Opportunities portfolios, we remain close to a maximum allocation to high yield bonds in both traditional mandates and our mandates with a focus on sustainable and ethical investments and have a large allocation to the BB segment.

Best regards,

Mads N. S. Pedersen

Managing Partner and CIO

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