International equities

The MSCI World (excluding Australia) Net Total Return Index (AUD) returned 7.6% over the past three months and 22.6% over the year to 30 June 2023. Much of this return was driven by the decline in the Australian dollar with the MSCI World (excluding Australia) Net Total Return Index (hedged to AUD) returning 16.6% for the year to June, a differential of 6%.

MSCI World excluding Australia Net Total Return Index (Jun-22 to Jun-23)

The outlook for international equities remains challenging as numerous headwinds remain apparent. First, monetary policy remains unsupportive. Central banks have shown a strong commitment to combat inflation with higher rates, particularly in the US and Europe. This suggests that current interest rate levels may persist until we see broad-based economic weakness, such as significant job losses. The longer this scenario persists the greater the risk of lower asset prices as investors move capital to safer options such as cash. The chart below highlights the short-term risk reward with the S&P 500 forward earnings yield i.e. next year’s expected earnings divided by its current price sitting barely above the cash rate. It raises the question of how wise it remains to take on equity risk when safer options are available.

Spread between S&P 500 Earnings Yield and Fed Funds Rate (Sep-96 to Jun-23)

S&P500EarningsYieldLESSFedFundsRatemidpoint(Sep-96toJun-23)

USrecession Spread(S&P500EarningsYieldLESSFedFundsRatemidpoint)

Source: Bloomberg

We also harbour concerns that the outlook for slowing economic growth is not adequately reflected in earnings forecasts. The US is still predicted to grow profits approximately 7% per annum over the next three years to 2025. This remains difficult to reconcile with the below-average growth outlook that we have highlighted earlier. If earnings disappoint further, as would seem likely over coming quarters, then the risk of further market weakness in the short-term is high.

Lastly, the geopolitical environment continues to be unstable. The war in Ukraine shows no signs of abating, posing ongoing challenges for the global supply of energy and food. A thwarted coup attempt in Russia by a private military force, the Wagner Group30, also highlights the ongoing challenges in the region and the risk of further disruptions for commodity prices if regional instability escalates.

On the positive side, valuations in some regions and countries continue to be favourable, particularly outside the US, with markets such as Europe and China trading at discounts to their long-term average price-earnings multiples. However, valuations in the US, which comprise just over 70% of the benchmark index31 remain unattractive, particular after a surge in technology stocks in the June quarter as interest in artificial intelligence (AI) applications soared

On balance, we believe the case for being underweight global equities continues to be justified and maintain our underweight position.

Over the June quarter we continued to observe rising share prices even as earnings expectations declined Two factors have been key. First, the rise of heightened speculation particularly amongst retail investors for artificial intelligence stocks, such as Nvidia, surged.

Second, speculation over a potential pause by the Fed and rate cuts subsequently has supported the relative attractiveness of stocks in the US and benefitted those with particularly long-term cashflows (dominated by technology names) This has resulted in the US market trading well above its long-term average valuation (as measured by its P/E ratio), an outcome which appears unsustainable given the economic headwinds

12-month Forward Price-Earnings Ratios for major markets (Jun-06 to Jun-23)

Source: Bloomberg; Data as at 27 June 2023

In the United States, operating earnings for S&P 500 companies are currently expected to decline by 1.2% in 2023, and then rise by 9.5% in 2024 and 2025, respectively. Assuming conventional long-term multiples, we estimate that the United States sharemarket (as measured by the S&P 500 Index) is overvalued by 19% in the near-term and by almost 3% in the medium-term.

30 As it happened: Putin survives rebellion, Wagner Group boss exiled to Belarus, Sydney Morning Herald, 24 June 2023, https://www.smh.com.au/world/europe/live-updates-putin-vows-to-defend-russia-against-wagner-rebellion-20230624-p5dj6x.html

31 MSCI World ex Australia Index (USD), MSCI, May 2023, https://www.msci.com/documents/10199/49479550-e805-4895-ba732893b1f3d60b

Source: Bloomberg consensus estimates for 2023, 2024 and 2025 as of 27 June 2023

In contrast, forward Price-to-Earnings (P/E) multiples for markets around the world are below longer-term averages as follows:

Source: Bloomberg. Data as at 27 June 2023.

Recommendation: Maintain underweight.

We believe consensus earnings forecasts remain overly optimistic. We expect earnings expectations to be downgraded further in coming months as global growth slows materially given challenges posed by rising interest rates and weaker demand. For these reasons we remain underweight.

By Cameron Curko, Head of Macroeconomics & Strategy | Pitcher Partners Sydney

Wealth Management +61 2 9228 2415 cameron.curko@pitcher.com.au