Potential Returns of Stocks and Bonds Exceed Cash

As the global economy continues to navigate through uncertain waters, the performance of international stock markets has been lackluster during the third quarter of 2023. Many investors are understandably apprehensive about the prevailing market conditionsNevertheless, analysts from asset management firms suggest that despite the ongoing risks, there are compelling reasons to maintain a proactive investment strategy in equities.

To illustrate the current climate, the MSCI World Index saw a decline of 2.5% in the third quarter; however, it remains up 11.2% year-to-dateJapanese equities have emerged as an outlier, rebounding significantly due to the country's exit from long-term deflationary pressures, thereby benefiting local businessesIn contrast, small-cap stocks in the United States have lagged behind their counterparts.

A closer look at sector performance reveals a significant retreat in technology stocks, which experienced a 5.7% drop after a robust rally in the first half of the year

Energy stocks, on the other hand, exhibited resilience with a 12% rise, driven primarily by supply constraints that helped boost oil pricesAlthough value and low-volatility stocks performed better than growth stocks in the third quarter, when considering the overall performance for the first three quarters of the year, growth stocks still substantially outperformed.

The cash flow yield of stocks is expected to grow over time.

Understanding potential stock returns is critically important.

Observing market performances in 2023 reveals a mixed sentiment among investorsOn one hand, there is concern regarding the lack of clarity in macroeconomic outlooks, while on the other hand, optimism surrounding the potential of artificial intelligence (AI) has emerged as a significant growth driver for certain companies

• Solidifying the Foundation for Data Value Release
• The Biggest Benefactor of AI!
• Patient Capital in Fund Investing
• US Jobs Surge Drives Dollar to 110
• AI Fuels French E-commerce Growth

In fact, AI was a primary catalyst for stock market momentum leading into the third quarter.

However, has the focus shifted back to macroeconomic issues as we enter the later part of the year?

While inflation appears to be moderating, expectations indicate that the Federal Reserve may maintain elevated interest rates for an extended periodIn simpler terms, real interest rates are expected to remain high, which typically exerts downward pressure on stock marketsNonetheless, economic growth and policy developments differ significantly across nations.

China has shown a rapid post-pandemic recovery, stabilizing afterwardsConversely, the European Central Bank raised rates in September, intensifying fears of an economic slowdown in Europe

In the United States, consumer spending has shown some resilience, yet economic growth momentum remains weak; in the event of negative occurrences, such as a cessation of student loan forgiveness, economic prospects could become increasingly complexStill, the Federal Reserve held interest rates steady in September, with recent forecasts suggesting a path towards a soft landing for the economy.

Against this backdrop, stock market investors must inquire: why invest in equities if interest rates could remain high for an extended period? How should one navigate the stock market in an environment of a soft landing or notable economic slowdown? Given that stock market gains this year have concentrated around specific stocks, how do investors evaluate corporate earnings and valuation risks?

Admittedly, in the current environment, investors might wish to avoid risky assets

With cash deposit rates being relatively high, why take on the risks associated with stocks? However, it is argued that while holding cash can be attractive in the short term, for long-term investors, such risk-averse strategies carry significant opportunity costs.

Within the prevailing inflationary environment, yield has become a focal point for many investors, and stocks can indeed be viewed as a source of incomeAlthough dividend yield is often the go-to indicator of stock returns, it is essential to also focus on free cash flow—essentially, the excess cash generated by companies after accounting for all operational costs.

Currently, the free cash flow yield from global equities appears less favorable compared to corporate bonds or cash; however, the long-term outlook presents a different picture

Market forecasts suggest that investors who allocate funds to global equities may only need to wait one year for free cash flow yield to approach the Bloomberg Global Aggregate Bond IndexLooking further into the future, projections show that the gap could widen even more significantly.

Research indicates that, compared to similarly situated corporate bonds, the cash flow yield from stocks is poised to increase over timeIn this context, it is particularly crucial for investors to grasp potential stock returns, as achieving real returns that surpass inflation is vital for fulfilling long-term investment objectivesRealistically, interest rates won’t stay elevated indefinitely, hence the potential returns from stocks and bonds will likely outstrip those from cash.

Even amid economic fluctuations.

Market trends and sectors are likely to persist.

So far this year, market reactions to economic conditions have remained relatively measured; however, should GDP growth rates falter or market volatility resurface, investors may face tougher challenges.

That said, the momentum driving stock market growth is not solely rooted in the economy; some market trends and themes have the potential to endure, remaining relatively insulated from economic slowdown

Amid the global push for renewable energy, industry structures are undergoing transformation, with large-scale public funding directed towards sustainable energy and electric vehicle sectorsAdditionally, the global trend towards electronic payments continues, alongside a significant rise in mobile data usageIn healthcare, DNA sequencing and digital health are forecasted for strong growth in the coming years.

Similarly, defensive stocks are not limited to utilities and core consumables; companies with clear competitive advantages are better positioned to maintain their marginsFirms capable of generating substantial free cash flow, coupled with strong balance sheets, are likely to sustain operational flexibility during economic downturnsIn conclusion, an actively-managed portfolio that identifies opportunities benefitting from long-term growth trends while securing companies with robust fundamentals and operational support may yield superior long-term returns.

Passive investment in the AI sector carries heightened risks.

Focus on valuation discrepancies.

While the market often fluctuates in response to macroeconomic dynamics, the long-term performance of stocks ultimately hinges on two key factors: corporate earnings or cash flow, and the price investors are willing to pay

Among the U.Slarge caps that have performed strongly this year, companies boasting business dominance and AI leadership showcase robust earnings potentialHowever, with the anticipation of strong earnings comes the question of whether valuations may run too highThe answer varies by company, as there are no definitive conclusions yet regarding whether earnings generated during the AI boom will prove sustainable.

Investors relying on passive investment strategies centered around AI-related themes may find that the risks posed by valuations outweigh the potential earnings opportunitiesElevated valuations can sometimes result in painful corrections; one need only look at the bear market of 2022 for referenceFurthermore, with interest rates remaining high, investors should be vigilant of valuation differentials both between different stock styles as well as within the same style categories

Should elevated rates ultimately place pressure on large cap valuations, other growth stocks may emerge as more attractive investment opportunities.

Can investors strike a better balance between valuation and earnings risk? The answer is affirmativeA review across various sectors reveals that corporate balance sheets are generally in better shape compared to pre-slowdown economic conditions, boding well for sustaining corporate earnings amidst a stern macroeconomic landscapeInvestors can uncover reasonably valued stocks with compelling long-term growth prospects across diverse industries.

Take, for instance, the underperforming healthcare sector this year; projections for 2024 suggest a forward price-to-earnings ratio of 16.5 times, representing a 5.5% discount compared to the S&P 500 index's valuations

In comparison to the broader market, this sector offers an appealing view of free cash flow as wellWhen investing in the healthcare domain, active investors would do well to sidestep higher-risk, unprofitable small biotech firms, focusing instead on high-quality stocks that boast strong growth and defensive qualities.

Similarly, on a global scale, value stocks are currently significantly undervalued relative to the broader market; certain value equities tend to exhibit relative support during economic downturnsMoreover, these stocks stand to gain from manufacturing reshoring, energy transitions, and even from enduring growth trends related to artificial intelligenceIn the realm of technology, numerous high-quality, well-profitable tech companies are regarded as “behind-the-scenes” firms, presenting a more attractive valuation narrative.

In the specific market conditions of this year, strategies to invest in these sectors can help lay a solid foundation for the future

Your email address will not be published.Required fields are marked *