Since about mid-October there have been signs of a rally in European and UK markets. Partly this was due to how low valuations had got after a tough year, while the surprisingly low US inflation data (7.7% was the lowest level of annual inflation since January) was the catalyst for a sharp bounce. Markets have become choppier recently, however.

Dan Nickols (Investment Manager, UK Small & Mid Cap Equities) argues that, over the year as a whole in UK mid and small caps, there has been an absence of clear thematic leadership. “Growth and value stocks have periodically been going in and out of fashion,” said Dan. “What’s been different about this recent rally is that there has been more differentiation, with the likes of consumer-exposed stocks, financials and industrials leading the way while oil & gas, healthcare and utilities saw a more modest uplift. That paints a picture of momentum underperforming, and value strengthening, as the areas that had been strongest going into the rally have generally seen less of the benefit.”
A hunt for growth has played into the hands of small caps
It has been a similar story in Europe, according to Phil Macartney (Investment Manager, European Equities). “In a global sense Europe had underperformed for a while,” he said, “and so it was a beneficiary of the shift in momentum when markets rallied. When you dig a bit further down into European markets it looks similar to the landscape Dan was describing in the UK, with retailers and industrials among the strongest areas.

“What has been different, though, is that within sectors we’ve seen a tendency for quality growth stocks to outperform their value peers. In my view, that’s a reflection of markets looking for resilience and growth potential as we head into an economic backdrop that will be quite difficult.”

“That hunt for growth, helped by existing under-ownership, has also played into the hands of small caps, which have outperformed large caps in Europe over the last several weeks. Given the scale of previous underperformance from small caps, however, I’d argue there is still plenty of headroom there.”

For Dan Nickols, the anatomy of this rally in the UK has – within the context of the smaller companies universe – favoured the larger end of that spectrum. “In my experience that is fairly typical of the initial period of a market rally,” he said, “but as the smallest of the small caps get ever-more left behind it raises interesting questions for us as investors when we engage with company management, as the strong companies in that space face the decision about whether to perhaps acquire rivals for growth or simply to use excess capital to buy back their own shares, given how chronically low valuations have become, and generate shareholder value that way.”

Despite the market sell-off over this year as a whole, earnings have been relatively resilient so far. Although this raises the question of whether the worst is yet to come in that regard. How worried should investors be about that possibility?
Watch for earnings downgrades in 2023
“There’s no doubt,” said Dan, “that we’re headed for tougher economic times next year, so it would be hubristic in the extreme to say there is no grounds for concern about earnings. Looking at the data, we can see that earnings revisions are weighted about 60/40 in favour of downgrades over upgrades at the moment. I’d expect more downgrades to come, as the median earnings expectations for UK companies over 2023 and 2024 look way too high at the moment, in my view.”

“As investors we must therefore ask ourselves, firstly, how much might already be in the price. Beyond that, the approach we’re taking is to seek companies that seem to offer growth potential with good earnings visibility, combined with some more economically-sensitive names that have significant self-help potential (e.g. from cost initiatives) and/or stand to gain market share as attrition shrinks the competitive space in their sector.”
Resilience comes in many forms
Phil pointed out that the earnings picture in Europe this year has been supported by currency. “But as the tide of currency support goes out,” he said, “it’s easier to get a sense of the real picture and analyst forecasts have already started coming down quite aggressively. In the last month or so I’ve had a few companies talk to me about deflation, even to the extent that customers are postponing orders on the expectation that prices will come down, which I think is quite an interesting landmark in the narrative.”

“Most of all, what we look for in a stock in this environment is resilience. That can come in different forms. Most obviously, we look for companies that are market leaders with strong balance sheets that can ride out an economic storm, but resilience can also be visible in the ability of companies to create opportunity out of adversity. Energy infrastructure stocks are an example of that, as obviously today Europe is staring down the barrel of an energy crisis, but the impetus to adapt is strong and it wouldn’t surprise me at all if a decade from now Europe has the most energy-efficient economy in the developed world.”

UK and European markets each have their own peculiarities, but what Dan and Phil both underlined was the importance of active investors being able to identify not only companies that can come through a tough economic landscape unscathed, but also those that are able to capitalise upon the opportunities along the way.

The value of active minds: independent thinking

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