Why markets could be poised to bounce

FEELING in the stock market is always finely balanced, but now feels like a particularly delicate time.

By common consensus, economies are heading into a period of low growth and many will likely fall into recession. Inflation is leaving individuals poorer in real terms and businesses will be feeling the squeeze soon, if they aren’t already.

Yet the mood in stock markets is more positive than at perhaps any point this year. Prices have been rising for the past month as investors jump on any positive news that suggests inflation could be peaking, or interest rate rises slowing down.

That makes sense when you consider that it is the job of the market to anticipate and move ahead of economic changes. The market has been falling for most of this year in anticipation of tougher times to come and now, as the economic pain is being felt in earnest, it has already priced in a slowdown. Having started the year priced at around 24 times expected earnings, the S&P index representing the US stock market has been as low as 15 and stands today at about 17.

If news on inflation continues to improve, and in particular if markets gain confidence that the end of interest rate rises are in sight, then the recovery could gather momentum. There is clearly still the risk of the opposite scenario as well – that inflation remains stubbornly high and the downturn is worse than feared – which would likely trigger another leg down for shares.

But if you’re optimistic we are at or near the bottom for shares, which assets will do best in the recovery that follows?

Time for tech?

The overall market falls we’ve seen this year have been led by tech, particularly the giant US tech companies that make up a large share of that market. While the wider S&P 500 index has fallen around 17% in the year to date, falls among the big tech names have been much larger, with Amazon down 44%, Microsoft 26%, Meta (Facebook) 66% and Alphabet (Google) 32 %. These prices are in US dollar terms. Only Apple, down 17%, has kept pace with the market.

Those falls are justified on the basis that rising interest rates damage these companies valuations by discounting the value of their future earnings. That effect won’t be undone completely until interest rate rises peak and begin to fall back again. Even then we may not see interest rates at the low levels of a year ago for a very long time, if ever.

That said, there is still room for a substantial recovery for tech if interest rate rises turn out to be less severe than currently expected. Much will depend, also, on how badly the looming economic slowdowns worsen earnings expectations.

The risks are clear. Yet if earnings hold up then big tech may just look very attractive at these levels.

An important proviso is that unprofitable tech companies – those at a stage where they are still relying on borrowing – face additional challenges in the years ahead because borrowing costs will remain elevated. It is those companies generating plenty of cash that are best placed.

Those would include Apple, which is regarded as enjoying significant power to raise its prices. The company is also helped by the fact that it is less exposed to a downturn in ad revenue that could accompany a recession.

Alphabet, parent of Google, faces the headwind that a sharp recession will hurt ad spend in the wider economy, leaving its earnings vulnerable. However, the company is building out a powerful business in cloud computing that is less exposed to those cyclical factors. A milder downturn than is anticipated could see it make gains.

Microsoft is already the leader in cloud computing, and enjoys strong recurring revenue from its software that is unlikely to be ditched by companies even if trading gets tough.

For investors happier using fund to make their investments, Rathbone Global Opportunities Fund invests globally but with a focus on high-quality growth companies, including prominent US tech names.

Is small beautiful?

Small companies are generally a riskier prospect for investors than large companies. As they are in an earlier stage of their development, there is a greater risk that any one of them could fail. That perhaps explains why they have tended to suffer more during market sell offs when investors are taking risk off the table.

The flipside of that equation, however, is that small companies can rebound more quickly if there is a positive change in sentiment.

Once again, much will depend on the shape of economic performance from here. Recession tends to hurt most those companies that depend on their domestic market and creates jeopardy for those small firms with only limited cash reserves to see them through periods of tough trading.

It can make sense to use a specialist fund manager who knows under-researched small companies better than the wider market when you invest in small companies. Edinburgh Worldwide Investment Trust specializes in small companies from around the world with strong growth prospects. It’s a risky part of the stock market and gaining exposure via an investment trust can add volatility.

However, the Edinburgh Worldwide trust is currently trading on a discount of 9% versus the value of its assets. That’s a significant widening compared to the start of the year and means investors buying now are getting assets relatively cheaply.

Emerging markets to make the run?

As with small companies, small economies are often the first to feel the pain when global activity slows down. That has been the case this year with a strengthening US dollar adding to inflation in emerging markets which have to spend higher amounts of their local currency on goods priced in dollars.

But now a lot of that effect has been priced in, a point made by Jonathan Garner, Chief Asia and Emerging Market Equity Strategist at Morgan Stanley. “Valuations are clearly cheap, and cyclical winds are shifting in favor of emerging markets as global inflation eases more quickly than expected, the Fed stops hiking rates and the US dollar declines,” he says, adding that over the last several economic cycles, emerging markets have recovered before US markets.

Stewart Investors Asia Pacific Leaders Sustainability Fund has a long tradition of investing in the Asia Pacific region and seeks out companies with resilient balance sheets, good franchises, strong culture and a focus on sustainability.

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