How has weaker growth and higher inflation impacted stock market performance?

Inflation remains the dominant factor for financial markets. Central banks have taken a hard line on tackling rising prices and are only likely to slow when they show clear signs of peaking. For the time being, this peak remains elusive.

This means that financial markets will need to continue living with rising rates for a while. Even if inflation starts to moderate, central banks are unlikely to decrease rates and risk a revival in inflation. This has changed the dynamic for stock markets and will influence which sectors do well and badly into 2023.

Financial market impact

We looked at how stock markets have performed in a range of different scenarios, incorporating low, medium and high inflation, and low, medium and high economic growth. We paid close attention to the potential for stagflation: while inflation is set to be higher than growth for a while, we expect it to be moving in the right direction and falling from its current levels.

As might be expected, there is a clear trend for defensive sectors to outperform as an economy moves towards this environment of low growth and higher inflation. These include consumer staples, healthcare, utilities and also energy, which remains a clear beneficiary of high inflation — through higher commodity prices.

Looking at various equity factors, value performs well in this environment, while quality-associated factors also tend to do well. This makes intuitive sense: companies with robust balance sheets and strong pricing power should continue to thrive even as the economy weakens. Those companies with high debt, with undifferentiated products and a weak business model will be more exposed.

From a geographical perspective, the UK has historically done well in a high-inflation environment because of its relative lack of high-growth companies. Our research shows the US market performs well in a stagflationary environment in sterling terms, but some of this is attributable to the devaluation of the pound in 2008.

The weak spots

We found that high-growth areas suffer the most — notably information technology and communication services. The more economically sensitive value plays such as industrials and materials don’t perform well either. Many major economies are either in a recession or on the cusp of one, which makes it difficult for those companies that rely on economic expansion to grow earnings.

The momentum factor, which is sometimes associated with more growth-orientated companies, is notably weaker as economic growth ebbs. It is also associated with smaller companies. While smaller companies outperform over the long term, they struggle in all high-inflation environments.

‘Muddle through’ growth scenario

It seems likely that much of the world will now experience a shallow but prolonged recession in 2023. Defensive areas will likely continue to outperform as they have done for much of 2022. Areas such as energy, healthcare, industrials and financials are still below their long-term average valuations, in spite of the rally in more ‘value’-focused areas for much of the year.

The worst two performers in this environment are technology hardware and semiconductors. Software is also poor. This has also been borne out in 2022, with technology companies showing real weakness in earnings and a compression in valuations.

Not all gloom

Over 2022, earnings growth was relatively resilient. Certainly, there were some areas of weakness, but corporate pricing power has largely offset higher input costs. In some cases, prices have risen higher than input costs with companies charging more than needed to offset the increase of labour costs.

As such, earnings predictions for the year ahead remain relatively buoyant. In aggregate, analysts are now expecting growth of 4.5% for 2023 and 8.6% for 2024¹. To our mind, they look realistic, even with recession looming for many developed economies.

Markets have de-rated considerably and there is still scope for them to make progress from here. However, investors may need to accept that the environment has shifted. Higher inflation and interest rates require a different approach to stock market investment, but it does not argue against it altogether.

Sources

¹ Refinitiv / Evelyn Partners