While these challenges present substantial risks that we’re actively monitoring, they come against a backdrop of a moderately improving global economic outlook that could provide a buffer against further macro shocks. Given the opposing forces across today’s economic landscape, we currently see clusters of attractive equity opportunities—most notably in Europe and China, especially among economically sensitive cyclical stocks that we view as having strong quality growth characteristics well suited to today’s environment.
An economic transition appears to be at hand
As quality growth investors, we evaluate investments using four factors—quality, growth, valuation upside, and capital return—with varying emphasis based on where we are in the economic cycle. At Wellington, the Global Cycle Index (GCI) is a proprietary research tool that helps us gauge our position in the economic cycle, the relative intensity of investor risk appetite, and optimal factor weights across portfolios.
This index began to fall in late 2021 as the global economy was buffeted by headwinds such as inflation, rising interest rates, and other forms of policy tightening by many of the world’s major central banks. Based on historical experience, these downward cycles in the GCI normally take 12 to 18 months to hit bottom. The most recent cycle reached a lower bound at the end of 2022, and we’ve recently seen improved readings on consumer confidence, continued strength in labor markets, and incremental policy easing by selected central banks in response to moderating inflationary pressures. From a geographic perspective, the areas that we believe are leading the way out of the GCI’s downturn are Europe and China—markets where equity valuations fell in 2022 to depressed levels owing to the effects of the Russia-Ukraine war and China’s restrictive zero-COVID policies.
Early signs of Europe’s economic comeback
In Europe, we’ve recently seen improvement in consumer and business confidence and an easing of inflation, reducing the potential of a eurozone recession. Some of these developments can be traced to Europe’s avoidance of a feared winter spike in energy prices. Moderate weather across much of the Continent in recent months helped to keep energy demand in check at a time when war-related disruptions to Europe’s energy grid were far less severe than those experienced immediately after war broke out in February 2022.
Another positive catalyst relates to the extensive trade ties between Europe and China. We expect to see China’s economic growth accelerate in the wake of the government’s December 2022 removal of its zero-COVID policies, creating tailwinds for European trading partners. We believe increased trade with China may help add around 2.0% to GDP for the eurozone economy going forward as supply chain disruptions ease and delivery backlogs are cleared up. Furthermore, we believe that recent increases in European Union fiscal spending on energy efficiency, new energy sources, and defense may add a further 1.5% to 2.0% to GDP growth in 2024.
In addition, we believe that the European banking sector is resilient against the current challenges after more than a decade of building capital buffers and new regulations to prevent another financial crisis. The recent demise of Credit Suisse, a major Swiss bank, is a great example of how a potential disruptive collapse was dealt with in a relatively clean manner. Credit Suisse was an outlier within the banking industry, and we believe the rest of the players are well insulated from the U.S. situation and stand to benefit from the improved macroeconomic conditions in Europe.
This confluence of improving fundamentals across Europe has opened many attractive opportunities across the Continent’s equity market, in our view. Our disciplined process is leading us to high-quality cyclical, value-oriented stocks that have traditionally made up a large portion of Europe’s equity market, and we’re seeing many such opportunities across sectors, especially in industrials.
China’s post zero-COVID revival
While China presents an abundance of current risks from a geopolitical perspective, the government’s removal of its zero-COVID policies provided a catalyst that reinforces our view of China as a key driver of long-term global growth. For example, month-to-month manufacturing activity surged in February to its highest level in more than a decade, and a gauge of services activity also climbed. We regard China as a cyclical market driven by shifts in the government’s domestic and foreign policies. Over the past two years, strict public health policies coupled with a tightening of regulations governing Chinese technology companies weighed heavily on the domestic economy, which recorded GDP growth of just 3.0% in 2022—less than half of the 8.1% growth that the government reported in 2021.
The Chinese economy’s slowdown last year was a headwind for Chinese growth stocks, many of which we view as having fallen to excessively low valuations. However, we’ve recently seen a reversal, with the removal of COVID-19 policies and a dismantling of some of the prior regulations imposed on tech companies. These shifts have created new equity opportunities at a time when we expect to see a positive turn in China’s economic cycle.
These shifts have created new equity opportunities at a time when we expect to see a positive turn in China’s economic cycle.
We believe economic momentum will be fueled in part by the untapped potential of Chinese consumers. We estimate that they accumulated US$3 trillion to US$5 trillion in extra savings since the pandemic began in early 2020—cash that consumers were unable to spend in part because COVID-19 restrictions led to curbs on travel, leisure, and other services. This untapped savings could help accelerate China’s growth in coming months, notably for industries such as travel, hotels, and casinos. In fact, we believe that China’s GDP growth potential for 2024 is underappreciated; we expect growth of 6% to 7% in 2024 versus consensus expectations of around 4% to 5%. We view this growth potential as particularly beneficial to cyclical industries ranging from advertising to life insurers.
Today’s markets are influenced by strong macroeconomic forces, including government stimulus, rising interest rates, inflation, and regulation. As growth equity investors, we find it easier to navigate this volatile environment by adhering to our disciplined, structured philosophy and process. Looking to the rest of 2023 and beyond, we believe this approach to identifying potential companies with high quality, growth potential, valuation upside, and capital return to shareholders is especially important in this market.
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
The Global Cycle Index is Wellington Management’s proprietary index constructed to quantify trends in global economic activity and is a combination of seven components: industrial confidence, consumer confidence, capacity utilization, unemployment rate, global curve, policy uncertainty, and M&A activity. The index combines these seven forward-looking macro variables and assumptions to indicate the direction of the global economic cycle. Assumptions are based on historical performance and expectations of the future outcomes and, as such, the analysis is subject to numerous limitations. Future occurrences and results will differ, perhaps significantly, from those reflected in the assumptions.
Investing involves risks, including the potential loss of principal. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Growth stocks may be more susceptible to earnings disappointments. Hedging and other strategic transactions may increase volatility and result in losses if not successful. These products carry many individual risks, including some that are unique to each fund. Please see each fund’s prospectus to learn all of the risks associated with each investment.