As we said in our last report, a return to normality was never going to be easy after nearly a decade of super-easy money. 2022 illustrated this all too clearly, with the US Federal Reserve lifting rates seven times – four of them super-sized moves of 75 basis points. The result for investors was anything but plain sailing. All major asset classes declined and global balanced accounts suffered particularly as bonds and equities fell in tandem – the first time we have seen this on any scale in nearly 30 years.
As we enter 2023 there is some light at the end of the tunnel. US core consumer prices are down from a peak of 6.6% in September to 6% today, which suggests that central bank policy is finally gaining traction. This echoes developments elsewhere, with German and French inflation rates also falling, alongside a very welcome decline in oil and European gas prices. We may then be past the peak of the great inflation shock, but rising labour costs and sticky prices suggest that getting back to central bank target levels will not be easy.
Better inflation and energy data also explain the improving backdrop for financial markets last quarter. After a brutal start to 2022 across all asset classes, markets finally rallied in October, with global equities climbing 9%1 through to the year end, bond yields stabilising and credit spreads narrowing.
We are a long way from erasing 2022’s market losses but the decline in volatility in both bonds and equities and a retreat in the US dollar together suggest a more stable backdrop for 2023.
It’s too soon to sound the all clear
There remains a chorus of central bankers who look at today’s inflation, which is still a multiple of their targets, and say rates ‘still have a way to go’, as Federal Reserve Chairman Jerome Powell commented after last month’s US rate rise. Madame Lagarde at the ECB echoed this two weeks ago, saying she is ‘not yet done,’ and even the Bank of Japan joined the fray with a surprise decision to lift its target level for Japanese government bond yields last month.
This is significant because Japan is the world’s largest creditor nation, so a change in policy rates in Tokyo could materially alter global fund flows. In short, interest rates are likely to rise higher and stay there a little longer than markets currently expect.
Between Scylla and Charybdis
If central bankers squeeze too hard, then the US’s predicted soft landing could turn into a global recession and a collapse in corporate profits. On the other hand, if central banks ease interest rates while the inflation genie remains out of the bottle, then bond markets will take fright, risking another market-wide correction.
The journey is further complicated by two giant geopolitical events. The first is the brutal Russian invasion of Ukraine, which could become a multi-year stalemate. The second is the abrupt lifting of Chinese COVID restrictions, which offers real support for global growth later in the year, but greater risks and suffering in the short-term.
So investors have a delicate balancing act in 2023, navigating between the Scylla of global recession and the Charybdis
of renewed inflation. It will take strong nerves, ample reserves of patience, and the ability to act quickly when opportunities arise.
Most importantly, managers need a clear eye on the longer-term goal
Most importantly, managers need a clear eye on the longer-term goal – namely the steady accumulation, at the right price, of equities that will be at the core of a new world order. Whether it is renewing the world’s energy and transport infrastructure, automating factories and farms, or capturing a new wave of emerging market growth, it is an extraordinary time to accumulate long-term thematic exposure, but investors must remain wary of over-zealous central bankers.
Rising rates have claimed many scalps - there will be more
When global stock markets peaked a year ago the Fed projected US interest rates ending 2023 at around 1.6%; its current forecast is 5.1%. Tighter policy on this scale has already claimed scalps in listed markets, but it has also cleared away many of the absurdities of a zero or negative interest rate world:
- The global sum of negative yielding debt has largely The total now stands at US$254bn, down from US$18.4tn two years ago. Government finances will be the principal losers but more rational capital allocation will ultimately support global growth.
- Long gone are the days in 2019/20, when Mrs Merkel could issue German 10-year bunds at yields of minus 5% and be overwhelmed with demand - today they yield plus 2.45%. The end of negative rates is a sign of a more stable and mature Eurozone and a currency that is a more credible challenge to the US dollar.
- Crypto’s fall to earth surprised few traditional investors and the recent FTX debacle is typical of a market mania brought low by tighter Crypto may re-emerge as a genuine asset class – but good regulation and good title are two necessary first steps…
Where will the axe fall next? Probably in less liquid assets, namely commercial property and private asset markets, that have yet to reprice. The latter (see later article) could provide a very interesting entry point for new money in late 2023 or 2024.
Reasons to be cheerful
There are three factors that may help central banks contain global prices. Europe’s gas reservoirs are now 28% fuller than they were a year ago, and it would now take an extraordinary event to cause the catastrophic, zero-gas outcome feared in the early days of Russia’s invasion. In fact, Europe may be able to secure much of next winter’s energy supplies with minimal inflows. Gas prices in Europe are three times what they were two years ago – but six months ago they were nearly ten times!
Second, global supply chains are returning to normal. The Federal Reserve Bank of New York’s global supply chain index is close to its five-year average, echoing positive comments from the management of many of the companies we visit.
For China the journey is just beginning, but the speed of reopening suggests that the transformation in Chinese manufacturing output might be very significant.
Third, US and EU trade restrictions forced China to focus on intra-Asian trade – a boon for smaller Asian markets and emerging markets more generally. China’s trade with ten of its neighbours has grown a staggering 71% since US tariffs were applied in 2018, and its trade with India grew 49% over the same period. By contrast, trade with Europe and the US grew by only 23% and 29% respectively. This surge in Asian trade will only accelerate as China reopens.
The policy implications for us are clear: a decade of underperformance in Asian and global emerging markets may be reversing. Liquidity conditions in these markets will also rise sharply if the US dollar’s decline continues and oil prices are contained. All of the above argue for a marked increase in our exposure to Asian and global emerging equity markets over the coming year.
This increase will not be achieved overnight – travel to Asia has been limited and corporate governance and transparency can be weak in these regions. But in some areas these markets are already leading the West – including take-up of electric vehicles, surging solar generation across Asia and the extraordinary efforts to automate government payments in India.
Treading with care
Global markets are full of long-term opportunity, equity valuations are close to fair value (but not yet cheap), and corporate bond yields offer returns well above two-year inflation forecasts.2 But we still worry that the shadow of central bank policy hangs over markets. Tighten too much and you trigger Scylla’s global recession and a collapse in corporate earnings; throw in the towel too soon and you have the Charybdis of resurgent inflation. If Mr. Powell and his colleagues had to choose one fate, our feeling is it would be Scylla – so the risks of over-tightening policy in the war on inflation are real.
Hence, we are treading with care, keeping equity exposure modestly underweight except where we are deploying portfolio protection, reducing our positions in less liquid alternatives and gradually beginning our pivot toward emerging markets. In private markets, we have close to zero exposure today, but as valuations adjust downward and debt bites our Bread Street team will be ready to deploy in Summer 2023 or early 2024.
In all of this, we will be quick to respond as conditions change – if inflation gaps downward and central banks back off or if recession threatens corporate earnings, you will be sure to hear from us again.
1Bloomberg, MSCI, 31.12.22
2Bloomberg, Sarasin & Partners, 31.12.22
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