Uncertainty over inflation, peaking interest rates and slower economic growth rates present headwinds for corporate earnings next year. We believe a focus on quality provides the best means of navigating this environment.

History shows that companies with pricing power, strong balance sheets, durable competitive advantages and less cyclical earnings are better placed to deliver against expectations than the broader market. Furthermore, the ability of quality businesses to demonstrate greater resilience and do better in a range of economic scenarios make them look appealing in uncertain times, over the short and longer term.

The early stages of new regime

Inflation in many developed and emerging countries is lower than it was at the start of this year, although it's not back at levels that would allow central bankers to claim victory in their inflation fight. As a result, risk-free interest rates in many major economies are a long way from the 'world of low numbers' that has characterized the 15 years since the global financial crisis. That said, investors are expecting cuts in interest rates during 2024.

The transition to get to this point has not been plain sailing. Financial market volatility, pronounced investment-style rotations, and a flux of macroeconomic crosscurrents have marked the past two years. What's more, there are long-term challenges – the climate crisis, geopolitical rivalry and demographic concerns – that also cloud the outlook for investors. Next year, we could see very different scenarios playing out – from recession at one end, to inflation under control and back to business-as-usual at the other.

Given this range of scenarios we think that investors' focus should swing towards company fundamentals – rewarding those companies that deliver and punishing those that disappoint. As such, stock selection will be key to success.

What lies ahead?

Among the main economic scenarios, it's the backdrop of weakening global growth and lower inflation that we think will become the key focus for investors in the months ahead. Whether we see continued US economic resilience or a period of economic contraction (the more consensus view), the result will strongly inform investor sentiment that has been risk averse for much of this year, beyond the performance of a handful of US technology stocks.

Where we have observed greater global alignment previously, going forward we see a less synchronized world with greater regional dispersion in economic growth, policy trajectories, and sector leadership.

Identifying opportunities …

Regional equity markets will begin next year from different starting points (Chart 1), with US markets – including and excluding the big technology firms – at a clear valuation premium to others.

Source: Factset, Goldman Sachs Global Investment Research, November 2023.

China's disappointing recovery has weighed on emerging markets (EMs). Looking forward, though, there is room to be selectively optimistic at the stock level.

This is reinforced by the opportunity for policy support to gradually stabilize China’s property sector and boost consumer confidence. Additionally, attractive valuations versus other regions provide a reasonable starting point for stronger Chinese equity returns next year. Considering the options from the EM ex-China perspective, we find the structural growth trends in these markets similarly appealing over the long term, amid evidence of a de-correlation with China.

Japan is another market that’s worthy of investor attention on account of an ongoing period of progressive structural change. Recent corporate governance reform has been well received by the market and is likely to continue to drive shareholder value. Alongside a pickup in household spending, we see Japanese equities being well placed to extend gains.

… Whilst mindful of the risks

Elevated geopolitical tensions show little sign of resolution any time soon. Energy price shocks could materialize, triggering renewed inflationary pressures and impacting corporate earnings. Meanwhile, higher-for-longer interest rates and weaker growth could meaningfully bite into household, company and government finances.

For the first time in years, central banks are in a position to deploy a more traditional policy response if growth slows too much (i.e., by cutting rates). Our view is that central banks will cut interest rates next year. It's just a matter of when – probably earlier in 2024 for EMs and later for developed markets. As and when this becomes clearer, it will likely boost investor sentiment towards equities, and longer-duration growth assets.

Markets more half full than half empty

Despite the potential for recession in 2024, equity markets are currently pricing in a more benign economic environment going forward. This raises a few points to note.

Current equity valuations imply less scope for a significant re-rating in the near term. They also suggest more downside risk than was the case at the start of 2023. With the market expecting low double-digit earnings growth, any signs of earnings weakness will be penalized by investors. However, thinking longer term, the valuation picture is neither too hot nor too cold. That's because global equities' cyclically-adjusted price-to-earnings (CAPE) ratios are still in the middle of their historic range, which review a 10-year period to smooth out short-term fluctuations.

Equity prices in the middle of the CAPE range imply annualized returns of 8% over the next decade. These are comfortably higher than US 10-year Treasury bond yields and in line with average global equity returns investors have enjoyed over the past 20 years.

In the short term, though, we see little support from valuations, and earnings are likely to be the primary driver of markets next year. That's why we believe a quality approach to equity investing will come into its own, given relatively fewer companies will demonstrate resilience and more sustainable growth profiles in a potentially tougher business environment.

Final thoughts

With global growth running out of steam, it's reasonable to expect that not all companies will be in a position to thrive next year. The winners this year are not necessarily those that will drive stock markets in 2024. That's why we think being selective is the order of the day. Steering capital towards quality businesses and investing for the long term are the best ways to mitigate equity risk and build exposure to sustainable earnings growth.

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