Investors ploughed money into growth stocks this year after a poor 2022, but they should not be so quick to run back into risky assets, according to JP Morgan global market strategist, Hugh Gimber.
Equity markets performed well in the first half of the year despite a concerning monetary backdrop, with Gimber warning that growth assets could be in for another derating.
Indeed, markets became overly optimistic about falling inflation and ignored the fact many equities have not priced in the eventual economic slowdown to their recovering valuations.
“We do not subscribe to the idea that immaculate disinflation is possible,” Gimber said. “It will come down, but only with a weaker economy. We're uncomfortable that markets are feeling quite so cheery.”
Instead, Gimber said “this is a time to be thinking about diversification and about taking some chips off the table” rather buying these risky assets.
The stark juxtaposition between last year’s underperformance and 2023’s rally makes Gimber uncomfortable, with concerns that this wave of positive sentiment is “too good to be true”.
Markets returns in 2022 vs 2023
Source: JP Morgan
“This really drills down into this concern that we have,” he explained. “I think you look at this graph [above] and see for the first nine months of last year that investors were convinced we were back in the 1970s. Now, markets seem to have moved too quickly from one side of the boat to the other.”
Gimber correctly anticipated a recovery in equity markets at the start of the year, but said it has gone too far in the other direction.
“There was a lot of doom and gloom about the prospects for the economy, but we felt at the time that the effects of the market sell off in 2022 had done a pretty decent job of reflecting the slowdown that we were likely to see in economies,” he said.
“It wasn't so much a case that our macro view was much more upbeat [than consensus], rather that market valuations had done a good job of reflecting future weakness. If you update that view now six months forward, really things have changed a long way.
“There's been little change on the macro, I think our big problem now is that we feel markets are much less well prepared for the slowdown that we still think is necessary.”
With an economic slowdown on the way, Gimber expects risky assets to take another hit, especially in the growth sectors that performed well this year.
Funds in the IA Technology & Technology Innovation sector have been the best performers this year, climbing an average of 22.5%, but these assets tend to drop the furthest in a recession.
MSCI World IT sector returns vs broader index earnings
Source: J.P. Morgan
With so many portfolios tilted towards technology after its staggering success over the past decade, Gimber said investors may want to consider how concentrated their portfolios are towards certain sectors.
“We're becoming slightly uncomfortable because the chart highlights the dangers of recency bias for investors today,” he said.
“It is very unusual for earnings to weaken across the market and for technology earnings to not follow suit.”
Indeed, the average IA Global fund has its largest allocation towards technology (25.6%), which could leave investors vulnerable if markets turn.
“This is a period where investors need to be particularly careful about very concentrated markets,” Gimber said. “For active investors, this valuation dispersion is a fertile hunting ground.
“Really questioning how resilient mega-cap tech earnings can be in the event of a broader earnings slowdown is one of the key themes that we've been picking apart recently.”
This will not be a short-term issue – Gimber anticipates repeated episodes of soaring inflation over the coming years.
He said many investors are looking to the past decade as a model to base their portfolio on, but need to be aware that markets are in “a very different place today”.
“The macro outlook is uncertain, so there’s a huge amount for investors to be doing today to take positive action to reinforce that resilience in portfolios across both equities and fixed income,” Gimber added.
Economic slowdown may be bad for technology companies, but Gimber said investors can strengthen their portfolios by focusing on quality businesses.
“In recessions, that’s where quality really does tend to outperform,” he added. “If as I described, there is a slowdown in the economy, we think a quality approach within the equity market is absolutely paramount.”
This doesn’t necessarily mean growth stocks – Gimber said there are opportunities for quality investing across the market, even within sector deemed risky and cyclical such as energy.