Preview: Inflation is expected to moderate as the economy slows and the labor market weakens, and as supply chain pressures ease and Europe diversifies its energy supply. A mild recession is predicted for developed economies in 2023, but both stocks and bonds are looking increasingly attractive, with bonds being particularly attractive for the first time in over a decade. The broad-based sell-off in equity markets has created opportunities in climate-related stocks and emerging markets, particularly in cheaper stocks that have already priced in a lot of bad news and offer dependable dividends.
- In the US, households did a good job of locking in low rates a couple of years ago, so the recent increase in interest rates won't impact disposable income as much.
- Some UK households have protected themselves from the near-term hike in rates by locking in a fixed rate mortgage for only two years.
- Those with cash savings will see their disposable income rise as interest rates increase, particularly in continental Europe, where fewer households have a mortgage and savings are higher than in the US and UK.
Europe is weathering the energy crisis well
- For Europe, the key risk is less about a housing bust and more about energy supply. However, due to good judgment and good luck, Europe looks increasingly likely to make it through this winter without having to resort to energy rationing.
China to open up post Covid, easing global supply chain pressures
- The Chinese economy has been faced with a different set of challenges to the developed world, with widespread lockdowns still in place to contain the spread of Covid-19. A rebound in growth in China could ease supply chain disruptions and lower inflation.
Inflation panic subsides, central banks pause
- Inflation should ease through 2023, with the shrinking contributions from energy and goods sectors helping to moderate price pressures. However, wage pressures also need to ease to be sure that we're out of the inflationary woods.
- Job vacancies are still exceeding the number of unemployed in all major regions, which suggests wage growth should ease.
- We see US interest rates rising to 4.5% in the first quarter of 2023 and stopping there, while ECB interest rates are expected to pause at 2.5%-3.0%.
- Central banks have ambitions to reduce the size of their balance sheets by engaging in quantitative tightening, but we do not expect a particularly concerted effort or any significant disruption.
Recessions to be modest
- Inflation will respond to weakening activity in the coming months, and the central banks will be happy to pause.
- Some bearish forecasters believe we have returned to a 1970s inflation problem, but this time round, investment and housing growth has been more modest, and the commercial banks are extremely well capitalised and stress-tested to ensure they can absorb losses without triggering a credit crunch.
- Busts follow booms, but the last decade's boom was notably absent. We do not expect a lengthy or deep period of contraction, and both stocks and bonds look increasingly attractive.
- This year's record-breaking drawdown in global bond markets has added to fixed income investors' woes. The correction is nearing completion, with the market pricing a terminal rate close to 5% in the US, around 4.5% in the UK and near 3% in the eurozone.
- Looking forward, the income on offer from bonds is now far more enticing, with yields approaching double digits and valuations around long-term averages.
- The correlation between stocks and bonds has been so punishing for investors this year that we think this time both asset classes' prices will rise together. If inflation dissipates quickly, central banks may pause their tightening earlier than forecast or even ease policy, supporting both stock and bond prices.
- Within credit markets, we believe that an "up-in-quality" approach is warranted. The widening of spreads on US HY credit is largely driven by the increase in government bond yields.
- Our 2023 base case of positive returns for developed market equities rests on a key view that a moderate recession has already been priced into many stocks. Value stocks, however, are now quite reasonably priced compared with history, and we believe they will be higher by the end of 2023.
- The consensus 12-month forward earnings expectations currently look too high, and a recession is likely to lead to further reductions in earnings expectations. However, we believe that the market has already priced in some further downgrades to consensus forecasts.
- We note that the interaction between consensus earnings forecasts and markets has been inconsistent over time, and that falling earnings forecasts could lead to limited further downside for reasonably valued stocks.
- The stock market has already declined much more than usual before jobs have started to be lost, so the risk of further downside has improved, and the probability that stocks will be higher by the end of next year has increased sufficiently to make it our base case.
- Our base case sees a moderate recession in most major developed economies in 2023. Stocks with attractive income appear more reasonably valued than those with little or no income.
- The income stream from dependable dividend payers can also help buffer returns. The universe of companies currently paying healthy dividends is fairly diverse, spanning a wide range of sectors, and we believe these companies will continue to grow their dividends over time.
- Even though we expect a challenging macroeconomic environment in 2023, we think income stocks could have a good year with dividends proving more resilient than earnings.
1. The Fed pausing
- The Fed, other large central banks in Europe and changing consumer patterns are slowing down growth and hampering global manufacturing. North-east Asian markets have been hit hard by these factors.
- Given our base case macro outlook of a modest recession in the US and Europe, and retreating inflation in 2023, cyclical stocks and markets would find favourable environments.
2. The end of the zero-Covid policy in China
- Beijing has stuck to a restrictive lockdown policy through much of 2022, but a gradual easing of Covid control measures has re-ignited confidence that China is moving incrementally towards an ending of its zero-Covid policy.
3. Abating political risk
- Emerging markets were hit hard by an escalation of political risk in 2022, with Russian equities becoming un-investable following the Russia-Ukraine war.
- While political outcomes are hard to predict, investors should acknowledge that abating political risks are a possible outcome in 2023. For attractively valued emerging markets to shine in 2023, at least one of three featured catalysts need to occur.
- The strong performance of oil and gas companies has led many sustainably tilted strategies to underperform benchmarks, and surging bond yields prompted a broad-based growth sell off.
- Fossil fuel companies have outperformed global stocks by more than 50% in the first 10 months of 2022, while strategies that tilt away from the traditional energy sector have been more nuanced.
- In Europe, the energy crisis has forced governments to prioritise energy security, but the bigger picture is that Europe needs to reshape how it sources and uses energy, and fast. An accelerated rollout of lower priced renewable projects is the only medium-term solution.
- Fears around windfall taxes may be one reason why earnings optimism has not been fully reflected in prices so far. However, any impact of windfall taxes on renewable providers would be far less than for traditional energy companies.
Sticking with sustainability
- Moderating inflation and stable bond yields could help companies push for technological breakthroughs, and therefore be less sensitive to changes in discount rates.
- Sustainably minded investors should look to green bond markets for growth next year, as governments and corporates across Europe look to raise capital to tackle environmental challenges. The key for investors is to scrutinise covenants for measurable and specific targets, and ensure that proceeds make a material difference.
- In sum, many investors will end 2022 feeling battered and bruised, yet we believe it would be short-sighted to shun the sustainable agenda as a result. Policy tailwinds look set to combine with improved valuations and a more conducive macro backdrop to create investment opportunities.