From an economic and investment perspective, 2022 has been extremely challenging with both bonds and equities suffering very large drawdowns at the same time. High inflation, slowing growth, monetary tightening, soaring energy prices and rising geopolitical concerns have largely characterised the global economy and financial markets throughout 2022. Against such a difficult background, virtually all asset classes have declined although energy related plays and the US Dollar have been notable winners. Looking ahead to 2023, it is likely that disinflation together with economic and policy desynchronisation will be the defining macro themes that shape the investment landscape. Although the outlook remains problematic, asset prices should rebound as falling inflation allows central banks to cease their monetary tightening with rates expected to fall in the second half of the year.
Inflation remains the key factor for markets and the global economy
Inflation remains the key factor for markets and the good news is that inflationary pressures have clearly peaked in the US and Europe, assuming that the energy shock is largely behind us. This is mainly thanks to the impact of monetary tightening, falling commodity prices, easing supply constraints, and weakening demand. A strong Dollar has also helped in the case of the US, where investors now expect inflation to fall back towards the pre-pandemic 2% level over the next year or so. This is important since central banks will be keen to prevent longer-term inflation expectations becoming entrenched, which would change consumer and corporate behaviour and be much harder to address.
The Fed is committed to raising rates towards 5% by early next year since it remains concerned about wage growth and “sticky” core services inflation. However, with unemployment picking up as growth weakens and rents starting to fall on the back of a deteriorating outlook for housing and construction, this should persuade the Fed to turn more dovish early next year. In Europe, where high inflation is more about higher energy prices and supply disruption rather than liquidity-fuelled excess demand, inflation is also expected to fall rapidly next year. This should enable the ECB and Bank of England to pause rate hikes soon, although they both face a very difficult task as they balance the containment of inflation whilst supporting very fragile economies. Markets currently expect rates to peak around 4.5% in the UK and 3% in Europe in the first half of 2023 and to be falling by the end of the year. We also need to remember that inflation is not a global problem. In China, for example, the economy is in a tough recession, brought about by a bursting property bubble and its zero tolerance Covid policy, and deflationary pressures are evident.
Over the next year or so, the global macro background could feel quite disinflationary, especially if the Fed over-tighten and cause the recession to be deeper or longer than expected. Having raised rates too aggressively in 2018 and kept policy too loose in 2020/21, it is likely making another policy error as it seeks to squeeze excess demand out of the system at a time when debt levels are high and recession is about to bite. However, longer-term, the debate between inflation becoming a more secular problem (akin to the 1970s) or a cyclical issue remains finely balanced, and nobody can be sure. I can still make a strong case either way but I am now of the view that higher and more volatile inflation is here to stay due to four key factors; shrinking work forces, de-globalisation, a higher cost of energy and central banks having to keep rates lower than they should be due to record debt levels and to finance growing fiscal deficits.
The global economy is in recession but investors will start to discount an improving picture
Global growth is slowing rapidly and is expected to be in recession (under 2% growth) for 2023. In addition, we are likely to see an increasing East-West divide in terms of economic and monetary policy during 2023, which will have major implications for investment strategy. Specifically, growth in the West is forecast to be soft with the US, UK and Europe all in recession. The depth and duration of the US slowdown will probably depend on how quickly the Fed pivots and changes policy in the face of softening inflation. The UK recession is expected to be tough given the combination of falling real incomes, higher borrowing costs, rising unemployment and tighter fiscal policy. The UK economy now looks set to endure a substantial real reduction in government spending over the coming years, which will be painful given the pressure on health, pensions and energy spending from an ageing population and higher inflation. Europe also faces a challenging outlook, largely because high inflation is forcing the ECB to tighten monetary policy at the same time as the region is being hit the hardest from the Russia-Ukraine war and resultant energy crunch.
The Chinese economy is in recession as it struggles with a bursting property bubble, a weak banking sector and its Covid policy. However, in recent weeks, China appears to have abandoned its zero-Covid policy as it realises it is fighting a hopeless war that is rapidly losing public support and that the financial cost of maintaining such a policy has become prohibitively high. The Chinese government has also changed its approach to the property sector and is launching a series of policy initiatives to support and stimulate the sector. The Chinese recovery will be gradual and lumpy, not least because it will take some time for herd immunity to be reached, but 2023 should see a significant acceleration in economic activity as exports, consumption, government spending and investment all improve. A stronger China will be a major boost for the global economy, especially if it coincides with a shift to more accommodative monetary policies from the Fed and other central banks. In addition, inflation in Asia has remained low, which has enabled many central banks to either ease policy or not tighten as much as their Western counterparts. As inflation falls allowing the Fed to change tack, Asian central banks will be in prime position to further ease policy. Asia is therefore ideally placed to benefit from continued economic expansion in 2023.
We are more optimistic on the outlook for bonds
Turning to investment strategy, we believe it is time to selectively increase exposure to fixed income and extend duration. Bonds have suffered their worst drawdown in over a century and now offer attractive valuations, even if inflation falls slower than expected and rates subsequently stay higher for longer. In other words, bonds have likely discounted all of the bad news about inflation and will benefit from the Fed, ECB and BoE turning increasingly dovish as they battle a recession or major growth slump next year. As I have previously pointed out, nobody from the Fed down has any clarity or conviction regarding the future path for inflation or growth. It is certainly possible that inflation takes years to return towards the 2% level or settles in a higher range, which will clearly have an impact on interest rates. However, the markets are currently expecting inflation to fall back quickly and if the Fed follow a path similar to previous recessions, it is also possible that rates could fall below 2% if disinflationary pressures prevail for a period of time. Bonds, and government bonds, in particular, also tend to outperform equities in the early stages of a growth slowdown or recession. US inflation-linked bonds (TIPS) also look attractive given high real yields and the uncertainty around longer-term inflation.
In the absence of a secondary inflation shock, which could be caused by another spike in energy prices, we expect US Treasuries, UK Gilts and other sovereign bonds to deliver strong total returns over the next year or so as yields and interest rates fall. They should also provide a good hedge in portfolios against weaker growth and the risk of a worse than expected recession. Credit markets have been hit hard this year from the combination of rising yields and widening spreads (difference in yields over the equivalent government bond due to higher risk of default). High quality corporate bonds are attractive from a yield and total return perspective and should benefit from lower sovereign yields and the eventual Fed pivot. However, lower quality issues, such as High Yield, appear to be discounting a very mild economic downturn and spreads could widen materially in the event of a deep recession and rising default rates. Emerging market debt has also fallen hard and valuations look attractive, however care and selectivity is required given the challenging and desynchronised macro backdrop.
There are reasons for caution, but equities should recover strongly next year
Equities are likely in the early stages of a new bull market and should gradually “climb a wall of worry” over the next 12-18 months, but the upward path will be volatile, fraught with risks and hesitant in the early part of 2023. The prospect of recession will negatively impact earnings and the Fed cannot yet declare victory on inflation. As the year progresses, we should get a lot more clarity around how quickly inflation is falling, the subsequent Fed response, the extent and duration of the growth and earnings slowdown and the re-opening of China. Hence, the bull market in stocks should gain speed and breadth over the next few months. Consequently, we are ready to increase equity weightings but remain conscious that stocks may not yet have fully discounted the pending recession and the impact on earnings. In addition, markets may be disappointed if the Fed stay hawkish, keep rates higher for longer or if inflation falls slower than expected.
There are good reasons for optimism; valuations have moved into cheap territory for many markets as prices have fallen; earnings forecasts have already been downgraded significantly; 2023 should see an improving environment for liquidity, as the Fed and other central banks turn more dovish and growth recovers; equities have suffered a very large drawdown and both sentiment and positioning remain on the pessimistic side. In addition, the experience of the early 1970s, which was arguably a very similar period to today, suggest that equities tend to start their recovery earlier in a period of high inflation. For example, in 1974, equities bottomed at the same time as both interest rates and earnings peaked and recession hit. This is largely because earnings are nominal and driven by both price and volume, so if companies can pass on higher input costs, then revenues hold up well. Hence, markets are more sensitive to interest rates and financing costs than earnings in a high inflation world.
We continue to look for selective opportunities to add to equity weightings. In addition to our core themes, which remain attractive on a long-term view and look considerably cheaper from a valuation perspective, we also favour a number of other sectors and regions. Commodities, including energy, are likely in a secular bull market and related stocks should perform strongly. Cyclical stocks, such as industrials, and mid/small cap equities also tend to perform strongly once rates have peaked and investors start to look forward to an improving growth outlook. US large cap growth stocks have fallen materially over the past year, but they remain expensive and the sector faces a number of headwinds, including higher wage and commodity costs, weaker demand from China, disrupted supply chains and increasing regulation and taxation. Hence, we will look to selectively add to the sector, but price and quality are key.
There is also a strong argument in favour of reducing exposure to US equities in favour of international stocks on the following grounds; US equities are more expensive than many overseas markets; The Dollar will likely weaken in 2023 and the US market tends to underperform the global benchmark in such periods; China’s reopening and policy easing will be bullish for commodities and related markets. Hence, international (non-US) equities hold the potential to deliver better-than-average returns and it therefore makes sense to increase weightings. In particular, emerging markets are cheap in relative and absolute terms and should benefit from a stronger China, a less hawkish Fed, a weaker Dollar and the improving growth outlook for Asia.
The US Dollar bull market is coming to an end but any depreciation will be gradual
The 2-year US Dollar bull market appears to be coming to an end as investors start to discount the weaker growth outlook and a less aggressive Fed, although any depreciation will probably be gradual. Tighter Dollar liquidity, higher yields, a more aggressive Fed and the relative strength of the US economy have been the key factors behind the currency’s appreciation. The Dollar’s yield advantage versus other major currencies has likely peaked and is expected to narrow next year, perhaps materially if the Fed is forced to cut rates quicker than expected. A rebound in Chinese growth would also add to downward pressure on the Dollar as global capital flows would become less US-centric. Sterling has strengthened significantly over the past couple of months as the markets have welcomed the Sunak Government’s tougher fiscal stance and evolving economic strategy, although it remains undervalued on most measures. The Yen is also very cheap and has risen strongly over the past month or so as the Bank of Japan has intervened to support the currency and announced more flexibility around its upper limits for bond yields, thus reducing the yield disadvantage. The macro background for the Euro zone remains very challenging but the Euro should also strengthen versus the Dollar over the short to medium term.
Commodities, including gold, are in secular bull markets
I am bullish on commodities, Energy and gold for 2023 and on a longer-term view. A Fed pivot, weaker Dollar and a recovering China would lead to an improved global macro background beyond 2023 and push energy prices higher. A more uncertain and challenging geo-political environment and de-globalisation is also likely bullish for energy prices. In addition, global energy capex has been too low for too long, inventories are tight, and OPEC spare capacity may be smaller than generally realised. The broader commodities sector, including gold will also be a beneficiary of these same trends. Capex in the global mining sector has been very weak for years, reducing productive capacity. A strong revival in commodity demand can easily boost prices. As for Gold, prices tend to be negatively correlated with the Dollar and real interest rates and both factors should be moving in the metal’s favour next year. Gold also does well when market or geo-political volatility and risks are high, and when governments and central banks are busy printing money and debasing paper currencies. Although central banks have been forced to raise rates this year, they will find it increasingly difficult to maintain high rates given extremely high global debt levels and a probable shift to looser fiscal policies as governments tackle a number of challenges including income and wealth inequality, an ageing demographic, climate change, energy and food security and increased defence spending.
The changing World order presents both risks and opportunities
Looking longer-term, we are likely going through a once-in-a-generation period of economic, political and social change. The World order was already in transition before the pandemic struck but Covid and the Russia/Ukraine conflict has altered and accelerated some of the underlying themes and the way in which they are interacting. I think there are three key and evolving dynamic shifts coming together at the same time; a huge change in geo-political risks, an ageing demographic across many developed and large developing nations and a return to fiscal policy dominating over monetary policy. There are a number of sub-themes emerging below these main headings, such as globalisation going into reverse, shrinking labour forces putting upward pressure on wages, the debt super cycle, Governments facing a large and diverse set of challenges, which will require more spending, and the return of inflation.
A different investment strategy will be required for the next decade
Clearly nobody knows how these issues will evolve moving forward and the range of potential consequences and outcomes is huge. The global economic and market environment is almost certainly going to be more volatile, less certain and more changeable than we have been used to over the past twenty years or so. With that will come new and dangerous threats from an investment strategy point of view as well as some outstanding and attractive opportunities. Our job will be to try to make sense of the changing macro backdrop and adapt our investment approach accordingly as we seek to manage risk and deliver attractive returns for our clients. We are currently reviewing our major themes to gain an understanding of how they will be impacted by this change as well as looking for new themes that may emerge. We will continue to be thematic in our approach but recognise that the world is rapidly and dynamically changing around us, and we therefore need to react to this changing world through our thematic lens. One thing seems certain, the next decade or so will require a very different investment strategy to that which has worked so well for the past 15-20 years, which was largely based on low inflation, falling bond yields and interest rates, lots of liquidity and a relatively stable economic and geo-political backdrop. We will need to be more flexible, adaptable and reactive to change but are hopeful that we can still deliver attractive relative and absolute returns for our clients. Even if we are returning to an environment more akin to the 1970s with higher inflation volatility, the good news is that there was still plenty of opportunity to make decent investment returns.
The macro picture is changing. A few months ago, financial markets feared inflation and the continued rise in interest rates. In recent months that fear has shifted to recession. Inflation has not yet been crushed, but there is clear evidence that 2023 should see a return to disinflation and an easing of monetary tightening. Hopefully, this can be achieved with relatively modest economic pain. There are still lots of reasons for caution and the outlook remains uncertain, but we are hopeful that the economic environment will turn more favourable as the year progresses and that markets will also follow suit. It has been a very tough year for investors, one of the most difficult years in a century. The risks still need to be managed but 2023 should bring more cheer and a continuation in the market recovery that started a few months ago.
