UBS warns of more downgrades for ASX 200 shares… but not all

If now isn’t the time to be buying the dip, then when?

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Key points

  • It's too early to call the bottom of the market as ASX 200 shares are facing more earnings downgrades, according to UBS
  • The broker believes FY23 and FY24 consensus earnings forecasts are 10%-20% too high
  • But there are some ASX 200 shares that are well placed to outperform in this volatile cycle

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.

UBS added:

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.

ASX 200 shares to buy in this volatile period

Some of the mining shares on UBS’ buy list include the BHP Group Ltd (ASX: BHP) share price, the Newcrest Mining Ltd (ASX: NCM) share price and South32 Ltd (ASX: S32) share price.

The types of defensive shares the broker is bullish on include the Ramsay Health Care Limited (ASX: RHC) share price and Coles Group Ltd (ASX: COL) share price – just to name a few.

Motley Fool contributor Brendon Lau has positions in BHP Billiton Limited, Newcrest Mining Limited, and South32 Ltd. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has positions in and has recommended COLESGROUP DEF SET. The Motley Fool Australia has recommended Ramsay Health Care Limited. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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