Square Mile: CIO Mark Harries on markets in 2023

Mark Harries, Chief Investment Officer of Square Mile Investment Consulting and Research, offers his view on what markets have in store for investors over the coming months. 

Economic backdrop

• After rising steadily throughout the year, the final months of 2022 saw levels of inflation dip.  We expect this trend to continue in the coming months, but most important is where ‘core’ levels settle in the medium term. While the inflation we are experiencing began in the prices of energy and manufactured goods, it has now spread to services and to wages in particular.  
• Labour markets in the UK and US are at the tightest they have been in decades as populations have shrunk and legions of workers have taken early retirement.  As a result of this tight market, wages are rising by more than 5% p.a. and 6% p.a. in the US and UK respectively.  This is the data point we are watching most closely as this is what sustains a wage-price spiral, absent an improvement in productivity.
• We expect investors to be more fixated on economic growth than inflation in 2023.  Central banks are hiking interest rates to tame inflation with the side effect of slowing economic growth.  But the resulting higher unemployment is the best way to curb wage inflation, unpalatable as this might sound.   

• There is much talk about the recession: it is widely believed that any recession in the US will be both short and mild.  In the UK, investors also seem remarkably sanguine about forecasts from both the Bank of England and the Office for Budget Responsibility that the economy will remain in recession until 2024.  It seems to us that the current consensus could prove to be somewhat optimistic.   

Equity markets 

• While a recessionary environment might not seem supportive of equities, corporate profits are measured and reported in cash terms and can therefore grow despite this backdrop.   
• Companies with dominant market positions and strong pricing power should be able to continue to grow their top-line revenues; those more exposed to the cost-of-living squeeze will struggle to do this.  Costs are an important consideration and for many, wages are their biggest expense: controlled wage inflation is critical in protecting profit margins.  Falling revenues, spiralling wages and higher borrowing costs will prove a toxic mix for many companies in the year ahead and we believe there will be considerable divergence in share price performance across 2023.   
• For those investing in active funds, it will be important to favour portfolios with exposure to high quality companies with dominant positions and strong balance sheets.  Years of quantitative easing and negligible interest rates created a flood of cheap liquidity lifting all boats.  As liquidity diminishes, there will undoubtedly be shipwrecks in 2023, some of which will be high profile and headline-grabbing.   

Fixed income markets 

• After a brutal year for bond markets, the crucial question for investors is whether now is the time to increase fixed income exposure with yields now more appealing than they have been for years. 
• With yields in excess of 3.5%, 10-year UK and US government bonds are more appealing than they were twelve months ago.  However, those same yields averaged more than 5% in the decade preceding the financial crisis when rates of inflation were considerably lower and bond markets were yet to be distorted by quantitative easing.  
• There is a danger that the move to higher yields is not yet complete and that interest payments could be erased by further capital losses.   
• Spiralling levels of government indebtedness are also a concern.  In 2006, the UK’s debt to GDP ratio stood at 40%.  It is now more than 100% and increasing, not least because approximately one quarter of the UK’s debt pile is index-linked.  The interest on that debt in the current fiscal year will more than double to £120bn, more than the budget of any government department apart from Health.   
• Whilst government bond markets are now much more attractive, concerns persist.  There are emerging pockets of value, such as in short-dated, high quality, sterling corporate bonds where yields as high as 6% can be found.  There may also be opportunities to profit from the continuing volatility in the outlooks for inflation and interest rates which strategic and flexible bond funds are best placed to exploit.   

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