The financial year of 2022 was an extremely challenging year for capital markets. Geopolitics took center stage in the global capital markets in the outgoing year and not only rattled the global economy and capital markets but also disturbed international trade. This has implications for short-, medium- and long-term economic growth, and can potentially lead to reversals in monetary policies across the world.
The primary market also witnessed IPOs and subsequent listings are coming off their worst year this century. It has been nothing short of carnage for issuers, investors and underwriters. Volumes have collapsed around the world, and the 2020 and 2021 vintage of IPOs are mostly trading well below their initial offer price.
Review of 2022
The outgoing year has been extraordinary to mark the end of an era of the monetary easing phenomenon adopted by central banks across the world since the global financial crisis. A sharp and swift rise in real discount rates caused bruising losses across asset classes, ending the panacea that ‘lower for longer’ interest rates delivered for risky assets over many decades. Investors’ preferences and liquidity shifted from equities to money market instruments.
Mathematically, an investor with a portfolio of 60:40 in global equities and government bonds lost an eye-watering 17% during this year, which is an exception from the 9–10% investors would have grown accustomed to making over the last half century. Relatively, these losses were the steepest incurred in a generation, including 2008, which saw losses of ‘just’ 14%.
The first half of the outgoing year tested the nerves of investors when central banks around the world increase interest rates in their efforts to quench inflationary pressures. One of the biggest worries in the later half of the year was the timing of central banks to slow down, pause or even reverse their interest rate hikes. Certainly in 2022, the bulk of equity market movement can be explained by changes in the interest rate. As a result, the dividend yields generated by equities dwindled against corporate credit, particularly higher-grade investment bonds and Sukuk.
Interestingly, the Islamic equities outperformed their conventional counterparts in a period of aggressive interest rate hikes that tend to benefit banks which are heavily underweight in Shariah indices. The MSCI World Islamic Index declined by merely 11% relative to the decline of the MSCI World Conventional Index which declined by 17%, creating an outperformance of more than 6%.
The Islamic equity markets continued to outperform their conventional counterparts across all major regions (See Chart 2) despite challenging market conditions, which can be attributed to Shariah compliant stocks from the energy sector that rallied strongly, benefiting from higher oil prices caused by OPEC+ staged production cuts and supply worries caused by the Russia–Ukraine conflict despite lower consumer demand during the year. However, the technology stocks which are relatively overweight in Islamic indices were the major drag, as they recorded the longest streak of declines, highlighting significant pressure on their earnings growth as a result of tightening policies of global central banks and rising bond yields.
The primary equity market also painted a gloomy picture during the year with significantly lower issuances and proceeds. This marks a trend wherein IPO companies and investors were faced with mounting macroeconomic challenges, market uncertainties, increasing volatility and falling global equity prices.
As indicated in Chart 3, the Americas and Europe delivered a subdued performance amid secondary market volatility during the year. However, Asia and the Middle East bucked the trend in terms of proceeds and number of offerings. The technology sector continued to lead by the number of IPOs, although the average deal size came down, the energy sector overtook by proceeds largely driven by three of the global top five deals during the year and the consumer products sector witnessed the biggest drop in average deal size.
Preview of 2023
The equity markets are expected to remain volatile in the upcoming year, as the corporate earnings are challenged by the weak macroeconomic backdrop and subsequent margin pressure. But for the market to reverse the bearish trend, at least one of two things will probably need to happen. The corporate earnings will have to rise leading to a re-rating of equities as an asset class in the backdrop of a possible drop in yields, or else there needs to be an interest rate hike trajectory to slow down, pause or reverse to boost investor optimism.
The corporate earnings growth for the next year is quite challenging for several reasons. Firstly, the companies have been constantly talking about margin pressures in their last quarterly earnings reports, particularly due to an anticipated rise in wage and energy costs. Secondly, the operating and net profit margins are coming off historical high levels. Another downside risk is attached to revenue growth that could be lower than current estimates, as global GDP growth is downgraded continuously. Finally, the higher interest rates will force up corporate financing costs. It is estimated that around 20% of the outstanding debt is getting refinanced over the next 12 months, impacting the bottom line substantially. Having said that, corporate earnings expectations will be adjusted, perhaps significantly in some cases.
Furthermore, the market expectations need to adjust to a world in which money has a cost again. Growth can no longer be funded with limitless debt, and the threshold for the return on capital employed must rise. Ultimately, this development is healthy and may promote the survival of the fittest, favor quality companies and balance sheets and boost income for some.
Against all odds, the new year could be an opportunity to buy stocks and position portfolios for the long term. Investors need to look out for a potential equity market turnaround when the bad news for the economy become good news for equity markets as weakening economic activity will start to lean on inflation. This could bring a slower pace of rate increases — and eventually a peak in rates in 2023.
Furthermore, investors have to treat volatility as a potential opportunity during regime shifts which tend to bring volatility and disruption, but create an environment for active stock pickers rather than passive investments. First, consider anchoring portfolios with low-volatility strategies that blend defensive names. Second, explore quality value and growth stocks at reasonable price levels. Finally, consider high-conviction themes around key pillars such as national security (eg food, energy, water, cybersecurity), climate resilience and innovation (eg artificial intelligence) and sustainability.
The negativity of the secondary equity market, coupled with squeezed liquidity and higher levels of volatility, points to a tough ground to raise capital in the coming year. Entrepreneurs may continue to wait for more stable and positive stock market sentiments before raising capital through public offerings.
One needs to understand that IPOs cannot be launched overnight. It is a strategic decision and requires months of preparations with substantial legal and administrative costs. It not only involves internal stakeholders but also requires the services of bankers, attorneys, auditors and other experts. The companies need to enter into legal contracts and agree on a time frame and resource allocations. Therefore, the bearish secondary market conditions may not be the deterrent for all IPO-aspiring companies for a longer period of time.
Current market conditions require offerings to be reasonably priced because when a company goes public, the investors latch on to the revenues and earnings figures which research analysts forecast, usually with management’s guidance. The offer price will be roughly priced based on the valuation of relative listed peers on the basis of their forecasted earnings; then they have to offer shares to the public at a discount from the relative peers’ earning multiples.
Higher interest rates will affect the IPO-aspiring companies in many ways. The companies in the early stage of their life cycle might have taken advantage of low interest rates in years past to pile leverage on to the assets in order to drive up returns. So, if a company with a higher leverage ratio goes public, it will have to issue a lot of new shares to reach a more market-acceptable 2.5–3 times of the leverage ratio. Such a large slug of new shares will crowd out the ability of the going-to-public company to sell a large quantity of shares. Moreover, any refinancing will come at much less favorable terms in the current environment. So, the inclination will be to defer any IPO until operational cash flows can organically reduce leverage.
Considering these headwinds, it is unrealistic to expect the IPO market to be robust in the coming year. However, the IPO pipelines are waiting for the market to soften next year as activity remains strong in the background in anticipation of more favorable market conditions. Around 70% of the current IPO backlog is said to be in technology, healthcare and consumer assets. If market uncertainties and volatility subside, the launch of much-awaited blockbuster IPOs together with improved post-listing returns may reverse the sentiments and attract more companies to follow.
Conclusion
In an environment of slow economic growth due to soaring inflation and rising interest rates, the new year is expected to have less appetite for risky asset classes such as equities. The corporate earnings are likely to face tough challenges in such an environment. Further, the geopolitical tensions and pandemic-related disturbances are likely to infuse more market uncertainty and volatility. However, the defensive stocks with stable earnings, low leverage, visible free cash flow and capacity to offer higher yields could offer a modest upside potential particularly from consumer staples, financials, healthcare and utilities sectors. It implies that listed Shariah compliant equities offer better prospects, as they thrive on stable business models which are less exposed to interest rate hikes and other uncertainties.
The primary market investor sentiments are largely going to be defined by global central banks’ policies, rising interest rates, energy crises and the subsequent quantum of an economic slowdown. Therefore, the IPO market is likely to be sluggish in the upcoming year and candidates looking to go public for raising capital will need to be well prepared to re-price offerings at reasonable levels.
The views and opinions expressed in this article are those of the author’s independent personal opinion and should not be construed to represent any institution with whom the author is affiliated. You should not treat any opinion expressed here as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of an opinion.
Dr Mohammed Ishaq Ali is the head of equity at ANB Invest, Saudi Arabia. He can be contacted at [email protected].