Our market is staging a comeback, but it may be too early to bottom pick as many ASX 200 shares are facing more downgrades, according to a top broker.
The S&P/ASX 200 Index (ASX: XJO) peaked on 21 April and lost around 9% over the next three weeks. But improving risk appetite has helped it stage a recovery.
More pain around the corner for ASX 200 shares
However, the sell-off may not be over, according to UBS. The broker believes market expectations for earnings are still too high and equities may not find a bottom for another year.
The broker commented:
Stocks benefitted from unprecedented stimulus during the pandemic, but global central banks are now tightening at the fastest pace in decades.
This tightening is a good leading indicator of the growth cycle (with a longer lead than the OECD) and hikes signals continuing headwinds for equities.
Recession risks weigh on sentiment
UBS noted that 29 out of 37 central banks have hiked interest rates in the last three months. Some are early in their tightening cycle – notably our reserve bank and the United States Federal Reserve.
The tightening in monetary conditions in the US is probably enough to tip the world’s largest economy into a mild recession, according to the broker.
As the saying goes, if the US sneezes, we catch a cold. ASX 200 shares will not be immune to the US economic malaise even if our economy does not contract.
Why ASX 200 shares could face more downgrades
From that perspective, the recent derating in price-earnings (P/E) multiples for ASX shares is more the start than the end of earnings weakness. UBS pointed out that the contraction in P/Es led to a drop in earnings per share (EPS) by around six months.
Further, the EPS downgrade tends to lag interest rate hikes by around 18 months.
If you look at EPS realisation ratio, or how reported EPS compares to what was expected, current FY23 and FY24 estimates may be 10-20% too high (and PEs higher than they look).
We think it’s too early to buy the dip given downgrades are still modest.
When to buy the ASX dip
If now isn’t the time to be buying the dip, then when? The broker reckons a better time to buy ASX 200 shares is when EPS downgrades are more dramatic.
The only thing is that this may not happen until 2023, when UBS believes we would have hit the midpoint of the recession.
But it isn’t all bad news. The broker thinks that Australian shares will outperform US equities. It also believes the best way for ASX investors to weather the storm is to go overweight on ASX 200 resources shares and defensive shares.