After a tough year for markets, is all the potential bad news priced? Investors are certainly hopeful that 2023 will be more prosperous but in typical fashion it won’t be a smooth ride to making money.
In this article we debate some of the issues and how you might want to position your portfolio.
What will happen to inflation, interest rates and recessionin 2023?
Central bankers risk sending the world into recession to tame inflation. The only comfort is that economic contractions are disinflationary.
As we approach year-end, there is some debate among academics for the word of 2022. Among economists, ‘polycrisis’ – which refers to a combination of overlapping crises, such as a pandemic and a war – is the current frontrunner, for obvious reasons.
However, we would suggest the word of the year has to be ‘inflation’ as it has dominated everything from global energy prices and central bank policy to how we shop for groceries. As we look to 2023, we suspect it will subside of its own accord, for three reasons.
First, global supply chain imbalances are clearly easing which is important as this time round inflation has been caused by supply-side constraints rather than demand-side issues, i.e. not enough stuff where it was needed.
Second, in six to nine months’ time we will start lapping the double-digit price increases we experienced earlier this year. Third, economic activity is already contracting thanks to higher interest rates.
The JPMorgan Global Composite Output index fell for the fourth month in a row in November, and at the fastest rate since June 2020, while new orders also fell for the fourth month running with the rate of contraction the fastest in two and a half years.
Despite concerns about rising wages keeping inflation high, the global labour market saw a downturn last month with barely any new job creation while service sector activity is already signalling a contraction.
However, the US Federal Reserve is singularly obsessed with jobs and in particular the JOLTS (Job Openings and Labor Turnover Survey) data published by the Bureau of Labor Statistics.
Despite a clear slowing of the economy, monthly job openings are still running at more than 10 million or roughly two jobs for every applicant, which is anathema to the central bank.
Fed chairman Powell has vowed time and again to stick to his planned rate rise trajectory regardless of how badly it impacts the economy.
In his view, and that of other regional Fed chairs, the risk of not doing enough to slow inflation is greater than the risk of doing too much.
In their 2023 investment outlook, multi-asset strategist Peter van der Welle and head of multi-asset strategies Colin Graham at Dutch bank Robeco argue a ‘hard landing’ is now inevitable.
‘Having ended up behind the curve in 2021, central banks in Western economies this year swiftly morphed into dedicated inflation fighters. To regain their credibility, they now risk tightening monetary policy excessively into 2023, creating downside risks to the consensus soft-landing scenario,’ say van der Welle and Graham.
They add: ‘The culprit here is the lagged response of inflation, housing and the real economy to central bank policy tightening. However, once the ball gets rolling, it rolls fast.’
If there is any silver lining to this scenario, it is that recessions tend to be highly disinflationary. [IC]
What did we get right and wrong with our outlook for 2022?
In many respects 2022 was defined by the war in Ukraine and the markets are no exception. Anyone who read our outlook article in December 2021 would have been forewarned of the risk of conflict.
We observed at the time that ‘speculation is growing that Russian troops are ready to invade the country, possibly as soon as January’. Sadly, it proved correct.
We underestimated how persistent inflation would prove and, as a result, underestimated how far central banks would go on interest rates. Both areas were influenced by the impact of a grinding Ukrainian conflict which shows few signs of winding down.
We were right to suggest companies with quality credentials and lots of cash flow would be prized in 2022 and our warning that unprofitable technology stocks would be out of favour proved prescient.
However, our call that UK mid-caps would outperform the FTSE 100 was off the mark as a mix of commodities exposure, generous dividends and attractive valuations helped the UK’s flagship index outperform its global counterparts. We did at least point to the importance of dividends as capital gains from stocks would prove harder to come by.
Hopes for an M&A boom proved forlorn and our confidence in the continuing prominence of ESG (environmental, social and governance) factors was misplaced as focus turned from the energy transition to energy security. Our balanced perspective on emerging markets was the right one as some countries like Brazil and India shone but China and Russia had a shocker. [TS]
What happens to stocks and gold when the Federal Reserve stops raising interest rates?
Everyone is waiting for the US central bank to ‘pivot’ as this could trigger a new market rally.
There is a lot riding on the path of US interest rates and inflation in 2023. Economists have been talking about a US recession since the spring and if it happens it will probably be the most anticipated recession in history.
The popular narrative is also reflected in the behaviour of the US yield curve which briefly inverted in March before moving deeply inverted from June to its widest in over 40 years.
When the two-year yield moves above the 10-year, this is known as curve inversion, and historically it has presaged recessions.
The consensus view is that the economy will experience a short and shallow recession in 2023, which will bring inflation down and allow the Fed to ‘pivot’ and reduce interest rates from the current restrictive territory. Confirmation of the pivot is expected to trigger a big rally in the markets.
Swiss bank UBS says: ‘In our projection the central bank interest rate committee starts cutting interest rates in the third quarter of 2023.’
The problem for the consensus view is that economic data remains strong, especially wage inflation which came in above expectations again in November at 0.6%.
This leaves the Fed no option but to keep its foot on the brakes and yet again disappoint equity bulls looking for that elusive pivot. The idea that stocks will suddenly soar in the second half of 2023 is not a given – yet if it does happen then expect the rally to be fast and hard, meaning it might pay to be fully invested now rather than wait for confirmation of the strategy change.
‘We think attempting to time the market is a precarious exercise,’ says Kelly Bogdanova, portfolio analyst at RBC Wealth Management. ‘There is no bell that rings when a new bull market cycle begins. Missing the biggest rally days can have detrimental long-term performance consequences, and such rallies often occur unpredictably before all of the obstacles are out of the road.’
As an aside, it’s worth noting the strength of the US dollar which gained nearly 20% against a basket of currencies at its peak in 2022 reflecting higher interest rates in the US. A change in direction or pace of hikes for rates and easing inflation could therefore put the dollar into reverse.
Gold could rise in value if the dollar starts to depreciate, and investors might also look more closely at emerging markets which are often beneficiaries of a weaker US currency. [MG]
Will Chinese stocks soar, and which other parts of Asia should investors watch for 2023?
More relaxed Covid restrictions could provide a long-awaited boost to China’s economy.
Investors have high hopes of a recovery in Chinese stocks in 2023 amid expectations for relaxed Covid restrictions.
Widespread protests across the country have ratcheted up the pressure for the government in Beijing to drop the zero-Covid policy, even if Chinese premier Xi Jinping will be loathed to been seen as giving in to the protestors.
The risk is that China opens too quickly and sees another significant spike in infections, leading to risks its healthcare system could be overwhelmed. If such a scenario were to play out, then we would be faced with the unhappy prospect of another full lockdown in the world’s second largest economy.
Much will depend on plans to vaccinate China’s older population. Assuming China reopens then the most obvious beneficiaries will be Chinese stocks themselves, with the Hang Seng index already starting to recover after large losses earlier in 2022.
A Chinese reopening would also be good news for oil companies and mining firms given it is such a rapacious consumer of commodities. Luxury goods firms are another potential beneficiary as China’s middle class feels freer to travel – notably, Britain’s Burberry (BRBY) has large exposure to the Chinese consumer.
Other parts of Asia are worth watching from an investment perspective in 2023. India is on the cusp of overtaking China as the world’s most populous country and Morgan Stanley equity strategist Ridham Desai is excited about its medium-term potential.
‘Many investors view India as a market that disappoints expectations, but we see it as a quintessential self-help story. The fact is that over the past five, 10, 15, 20 and 25 years, India’s growth has only lagged China’s among large economies, and we believe that India can deliver outperformance.
‘It is one of the few countries in the world that is gaining from the disruptive global trends of demographics, digitalisation, decarbonisation and deglobalisation.’ The main impediment to the Indian market performing in the short term is the already strong showing for its stock market. Elsewhere, Vietnam will be looking to build on recent years where it has attracted significant overseas investment. [TS]
What’s the outlook for UK stocks?
The FTSE 100 has been a haven in 2022 but it remains cheap and unloved by overseas investors
‘UK equities offer significant value, with good earnings momentum, in a currency that is now particularly undervalued,’ says Invesco’s head of UK equities Martin Walker.
Truth be told, the UK stock market has been inexpensive for several years, with the FTSE 100 index currently no higher than it was in December 2017. The argument has been made repeatedly that UK equities should not be this cheap and that while they remain so, companies will be vulnerable to overseas takeovers, as the multi-billion-pound buyouts of Aveva (AVV), Meggitt and Micro Focus (MCRO) this year attest.
Foreign buyers had spent an estimated £52 billion on more than 500 UK companies this year (listed and private), according to data from the Office for National Statistics.
There is a theory that a broader pool of investors should see the light and buy UK shares. Some progress along that path was made through 2022, with the FTSE 100 one of the few major indices in the world to have not lost money for investors.
Abrdn Equity Income Trust’s (AEI) manager Thomas Moore says Rishi Sunak becoming prime minister heralds an era of more conventional economic policies. He believes this has already calmed the markets, helping to drive a reduction in gilt yields and a recovery in sterling.
‘As has been demonstrated by all the recent M&A activity in our own portfolio, some international investors are coming to the view that UK companies are now attractively priced. It would not take much for broader attitudes to the UK to improve dramatically,’ adds Moore.
Invesco’s Walker believes that in the fog of global and UK geopolitics, the quality of returns and the valuation opportunity on offer in the UK has been missed.
For example, the FTSE 100 currently trades on a forward price to earnings multiple of 11.4, based on Stockopedia data. The S&P 500 is on a PE of 18.4, according to research firm Birinyi Associates.
UK earnings have also been on the rise, with Invesco saying that consensus estimates for return on equity have increased by 19% this year, based on the FTSE All-Share. Despite this, valuations are down 19% in price-to-book terms.
The US equity market has derated by a similar amount to the UK (-21%), according to Invesco, but its return on equity has only increased by 3%.
The UK economy is predicted to shrink in 2023 as consumers struggle to pay soaring bills, rising rates squeeze mortgages, and widespread strikes slow recovery as workers chase pay hikes to match.
Jupiter’s Richard Buxton recognises these significant threats but believes that corporate and consumer balance sheets remain robust and employment high. Even so, few doubt that the UK is in for a prolonged recession, which could make for a challenging year for investors in domestic companies. Fortunately, there are plenty of businesses on the UK stock market which make their money around the world.
‘High-quality, cash-generative businesses with strong liquidity’ is where investors should be positioned, says Invesco’s Walker, stocks capable of emerging from market disruption and uncertainty in an ‘even better competitive position than beforehand.’
Thomas McGarrity, Head of Equities at RBC Wealth Management, says UK stocks should also appeal to income-seeking investors. He notes the FTSE All-Share index has the highest dividend yield among the major equity regional markets at over 4%. [SF]
Why are experts excited about bonds again?
Investors have the first chance in ages to find attractive levels of income from bonds
After one of the worst years on record for bond prices the starting point going into 2023 looks a lot more promising. After all, for the first time in decades investors can pick up a decent income from owning bonds.
One question on investors’ minds is whether government bonds can provide their usual diversification benefits during bouts of market volatility.
Ashish Shah, chief investment officer of public investments for Goldman Sachs Asset Management, believes they can. Referring to the classic 60% equities/40% bonds portfolio weighting, Shah says: ‘We expect 60/40 to work again, but we do not expect to return to the Goldilocks quantitative easing forever regime.’
The prevailing view across professional bond managers is that high quality corporate bonds and longer dated government bonds look attractive while it is too early to venture into lower quality credit.
JPMorgan strategists are in the positive camp, saying: ‘Increasingly, we believe bonds are again becoming a good risk hedge if we are correct in our expectation that inflation will eventually retrace back toward central bank targets.’
Rebecca Young, bond manager at Artemis, also sees core UK, European and US inflation approaching a peak which should remove a key headwind for bonds. Meanwhile, the repricing of bond prices has lifted yields significantly.
Young highlights the UK short-dated ‘triple B’ index which yields 6% compared with 1.7% at the start of the year. Triple B is the lowest rung on the investment grade ladder.
The positive view on bonds is tempered by market liquidity risks as explained by Megan Greene, chief economist at the Kroll Institute, who told Bloomberg she was concerned because around two thirds of US corporate bonds are rated on the lowest rung on the investment grade ladder.
A recession will likely induce stress on the weakest companies’ balance sheets and lead to their credit ratings being downgraded below investment grade.
This might spark forced selling by certain institutions which have restrictive investment mandates which do not allow them to invest in non-investment grade debt. [MG]
Where should you invest in 2023?
Investors mustn’t assume what worked in 2022 will do so again next year.
A popular view among investment experts is that 2023 could see an equity market rally – the key unknown is when it happens.
Quite a few asset managers believe the best strategy is to stay defensive with the type of investments held in a portfolio as we move into the New Year. However, be prepared to switch to away from defensive areas once there are enough signs that the Federal Reserve is going to stop raising interest rates.
‘We do not expect a pivot until there is a meaningful deterioration in hard data, especially inflation and the labour market,’ says Salman Ahmed, Fidelity’s global head of macro and strategic asset allocation.
‘The US housing market is already showing signs of stress, as higher mortgage rates and reduced affordability stifle transactions. However, inflation and the labour market are still strong, compelling the Fed to keep going, given its focus on current spot data against the backdrop of underestimating inflationary pressures last year.’
His colleague Henk-Jan Rikkerink, global head of solutions and multi asset at Fidelity, says government bonds remain the ‘go-to’ asset for portfolio diversification in a recession. He says the time will come to increase exposure to equities, but for now, the weaker backdrop is still not fully reflected in earnings forecasts or valuations. That implies we could see more volatility on the stock market before a rally.
Sonja Laud, chief investment officer at Legal & General Investment Management, shares this opinion and remains cautious about equity markets near-term. ‘Investors need to think about timing. We’re watching the market carefully, once there is significantly negativity priced into earnings revisions, you’ll have a much better entry point for equities.’
Asset manager Amundi also prefers a defensive stance with investments for now, favouring gold and investment grade bonds. However, it sees the second half of the year as being the point where equities become more appealing.
Once markets turn, investors may take profits in what’s done well such as energy and look at the more sold-off areas. European and Chinese stocks had a miserable time earlier in 2022 so they might be beneficiaries of a market rally in 2023 once investor sentiment improves as valuations have become more attractive.
On the UK market, housebuilders, retailers, property investment trusts and chemicals are among the worst performers in 2022 and so they might enjoy a relief rally if markets turn upwards next year.
The key risk to consider is that the US doesn’t experience a deep recession in 2023 and so the Federal Reserve continues to raise interest rates to get inflation back towards its 2% target. Without that ‘pivot’ from the central bank, we may not see a market rally – and that applies around the world, not just in the US. [DC]
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