“Both inflation prints and central bank guidance continued to drive much of the movement in markets throughout the final months of 2022. As inflation prints around the world appear to be peaking, the narrative in markets for 2023 is bound to change from “how much further central banks will continue to hike” to “what extent of growth slowdown should we expect ahead”. Market performance, and particularly the relative performance of equities versus fixed income markets, will hinge on the depth and length of such slowdown versus current expectations.
“While markets wait for clearer evidence, we are likely to see continued volatility in 2023. Besides the incoming data points on global growth, there are two other potential sources of volatility. First, while inflation across many countries is weakening with higher interest rates dampening demand and supply chains recovering, the tight job market (particularly in the US) is likely to maintain some degree of inflationary pressure for longer in 2023. Second, as we are indeed moving closer to the light at the end of the ‘rate hike tunnel’, with central banks likely to stop hiking sometime in the first half of 2023, markets are starting to build hope that the Fed will cut rates later in the year. I see this as unlikely to happen – unless we are facing a deep US recession coupled with inflation close to 2%, which is not our base case scenario. Importantly, I believe that the Fed will respond to such market expectations by maintaining a hawkish rhetoric as it risks de facto loosening monetary conditions by lowering rate expectations which, in turn, would make the Fed’s job more difficult and potentially force it to tighten more, and for longer.
A deep and prolonged recession is not priced in
“We all know that equities do not like recessions, and we believe that a deep and prolonged one – whether global or regional – is not priced in and would bring further weakness in equity markets. An S&P500 Index that is up approximately 22% from pre-Covid levels and down peak-to-trough less than half of the ca 55% experienced in the 2007-08 Global Financial Crisis, does not scream of panicked recessionary fears.
“Assuming a meaningful global recession ahead, the fixed income market appears better positioned than the equity market, with compelling relative valuations and yields that compensate for the risks ahead, especially if we expect inflation to come down and rate rises to be close to the end. However, as the last three years have taught us, beware of the unexpected. With expectations of a recession being increasingly entrenched – particularly in Europe – a milder-than-expected outcome, perhaps given a more normalised energy market, could be an unexpected bonus that would propel equities higher. Until data points provide more clarity, equity markets are likely in for a volatile start to 2023.
“In what, for now, feels like a continuation of 2022, the market remains one where selection is the main driver of alpha. Identifying upside performance requires drilling down into the details. Recent earnings pre-announcements, sales data points and initial 4Q22 earnings announcements, are showing a continuation of what we experienced last year – companies in the same countries and in the same sectors are showing very different results; as better market positioning, tilts in exposure, balance sheet strength and, in many cases, better management, help some weather the storm better than others.
“Importantly, the complexity of the current macroeconomic environment brings risks to both the upside and downside. A convincing resolution to the war in Ukraine, as distant as it may seem, would be a decisive positive – first and foremost from a humanitarian standpoint and, secondly, by bringing relief to commodity supply chains. Other less compelling, but nonetheless market-moving, data points we are closely watching are the evolution of labour markets in developed countries (the US in particular) and the ongoing energy supply challenges. A continuation of the persistent strength in labour markets might drive further inflation pressure, while a deterioration in conditions could shift the emphasis for policymakers away from inflation fighting. And despite the temporary relief from the stabilisation of oil and gas prices, longer-term issues remain in redesigning the energy supply mix across the globe.
Volatility ahead could rapidly change the investment outlook
“While recognising the relative attractiveness of fixed income markets versus equities, our Multi Asset team is mindful of the potential volatility ahead and of the factors that could rapidly change the cards on the table. For this reason, across our portfolios we are neutrally positioned on equities and have a small overweight on duration. The duration position hinges on the long end of the US yield curve and on emerging market local currency debt, which can expect to benefit from a peak in the US dollar cycle. We particularly favour Latin American sovereigns in this space given the high real yields and an inflationary outlook that, for the time being, seems largely under control.
“Within Equities, from a country standpoint, we have continued to add to China. We remain selective, but since adding in 2H22, we have rotated out of some stocks that had performed strongly and invested in others that were still reasonably valued. We believe the post-COVID reopening to be a powerful catalyst, not only for the domestic economy but also for the rest of Asia and, via increased commodity demand, other emerging markets. Some short-term volatility may come via a delay in a rebound in macro data points. This is because the long-awaited re-opening boost may face short-term headwinds given large Covid-19 infection rates and early Chinese New Year celebrations. That said, we believe the market will eventually look through these.
“Korea offers attractive investment opportunities as companies benefit from China re-opening and stabilisation, as well as a turn in the global tech cycle, especially semiconductors. We also find a number of attractively-valued names in Latin America, which benefit from global commodity price inflation and, in the case of Mexico, further near-shoring. In Brazil, investors remain understandably nervous about the return of President Lula and the economic and fiscal policies to be adopted by his administration. A fragmented Congress (which may water down some of the more market-unfriendly policies from the Lula administration), and avoiding stocks prone to political intervention, gives us confidence in the prospects for harvesting further alpha from a number of Brazilian equities.
“Performance in Emerging Markets (EM) across sectors and countries was very differentiated in 2022. We may see a further rise in stock dispersion in 2023, as investors drill down beyond macro considerations to focus on individual stock opportunities. Importantly, while EM equities look relatively well positioned, the biggest risk is that slower growth, disinflation and a peaking Fed rate hike cycle may tempt EM central banks to cut rates. Investors are likely to be wary of premature moves.
“Last, but by no means least, we continue to like Japanese equities and believe they represent a compelling long-term investment opportunity. The recent YCC (Yield Curve Control) band expansion by the Bank of Japan and the resulting higher yen is likely to put pressure on the margins of exporters and companies with high levels of debt. Yet, we find a number of companies that are improving operational leverage with a positive impact on earnings growth, alongside increasing shareholder returns via raising dividends and share buybacks.
“From a sector standpoint, we continue to find attractive opportunities in Technology. From an overall sector perspective we could see continued pressure due to higher interest rates and increased cost of capital. However, within the technology sector, the picture looks very differentiated. Semiconductors, in particular, stand out as benefiting from long-term structural trends.
Sustainability ecosystem has had a reset
“One area that seems to have pushed the reset button is the Sustainability ecosystem. Most Sustainable investment strategies had a testing 2022. A combination of inflation, rising rates and the terrible war in Ukraine led investors towards value stocks, commodity, defence and bank stocks – away from the type of stocks that typically dominate Sustainable and Impact strategies. The hefty derating in 2022 has removed the ‘ESG premium’ that some sustainable stocks had experienced towards the end of 2021, offering good entry points. Also, given the strategic shift to diversify energy sources and to curb energy consumption, along with the significant investment in renewables from governments on both side of the Atlantic, this area remains a compelling investment opportunity.
“Lastly, let’s not forget the convertible bonds market, which started 2023 with higher yields and lower equity sensitivity than has been the case in the last few years. Over 20% of global convertibles now trade below a price of 80% of their par value, and with a yield exceeding 10%. Most commentators expect new issuance to reach $70-80 billion during 2023, figures similar to the pre-Covid levels. Such an inflow of new deals compared to a market size of $356 billion, as at end of last year, would lead to a marked change in market characteristics. Convertibles are attractive to companies as they typically carry a lower coupon than straight debt in exchange for having the option to convert into equities. This may bring a more diverse set of issuers into the convertibles market, whether high yield names and investment grade issuers optimising their balance sheets.
“We are ready and positioned for 2023. More importantly, we continue to hunt for the ‘known unknowns’ hoping to shed a speck of light on the ‘unknown unknowns’. We are expecting surprises. This is not the time to make big sweeping macro calls but, rather, to follow the data and take advantage of the opportunities that any downturn presents. Importantly, selectivity remains key.”