A New Year, New Opportunities
January 10, 2023
First of all, we wish you a Happy, Healthy and Wealthy 2023!
2022 was a bad year for investors: the MSCI World Index fell 18% and the Bloomberg Global Aggregate Bond Index lost 16%. Which meant that a typical balanced portfolio consisting of 50% equity and 50% fixed income lost 17% – the worst performance in over 50 years. High inflation, slowing growth and monetary tightening have largely characterized the global economy throughout 2022. Wealth destruction was the dominant theme of the year. The global equity market shrunk US$ 15 trillion in market capitalization, while global bond markets saw US$ 30 trillion in value wiped out.
Basically, every asset class posted negative performance. Oil held up better, rising strongly in the first half but correcting in the latter part of the year as global growth expectations came down, ending the year flat. The U.S. dollar was the big winner, rising 9%. The big surprise of 2022 was that global bond markets suffered significant losses. Bond yields climbed as unexpectedly sticky inflation numbers triggered global central banks to tighten monetary policy aggressively. The massive surge in yields weighed on economic activity and created a headwind for equities. As a result, the stock-to-bond correlation deviated from its typical relationship as both equities and bonds sold off.
Central bank rate hikes in response to inflation pressures, rather than strong demand conditions, explain the change in the stock-to-bond relationship. Going forward, we expect the Fed to at least pause its current aggressive monetary policy in 2023 due to lower economic growth. Thus, the correlation between equities and bond yields is likely to be restored.
In contrast to the prevailing negative mood, our expectation is that global growth will surprise to the upside in 2023, while inflation pressure will ease substantially. This will allow central banks to pause interest rates hikes. At the same time, we believe that corporate earnings and profit margins will remain healthy, and that a lot of bad news is already priced in the equity markets. If growth indeed surprises to the upside and inflation falls back to the 2% to 3% range, there could be substantial upside in equity markets this year. And remember that markets move the most when investors expect it the least.
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Inflation: Here to Stay?
The answer to that question is yes and no. We believe inflation will come down rapidly in the coming months as pandemic and war-induced dislocations fade, the mix of spending between goods and services normalizes, and aggregate demand comes down in response to tighter financial conditions
In our view, inflation will eventually prove to be “transitory” and last year’s outbreak is mostly the result of the pandemic shock. As the pandemic-related economic dislocation normalizes and the Federal Reserve continues to tighten monetary policy, inflation will eventually fall back to the 2-3% range. Higher than what we experienced in the past decade but at much more normal levels than the past twelve months.
Core goods inflation in the U.S. is already falling, while inflation outside of housing is also starting to roll over. Owner’s equivalent rent is the only component holding up service sector inflation, but forward-looking indicators for shelter inflation are now dropping quickly. With aggregate demand continuing to slow, inflation will likely fade quickly in 2023. We need to keep in mind that inflation data is a rolling number, so it is not only important what the past month’s inflation number was but also what the same month’s number was 12-month ago. Keeping this in mind, it is possible that we will see a 2.5% annual inflation headline by June or July.
We believe that this will be very positive for global risk assets, even if economic growth slows. The British economist Alfred Marshall described how money interacts with stock prices. He stated that if money supply exceeds money demand, the residual is excess liquidity that can inflate asset values. This is referred to as the “Marshallian K”. Although this may sound fancy, it simply says that if inflation falls, there will be more money left for financial markets, fueling asset price inflation.
A Soft Landing
The conventional wisdom is that it will require a lot of economic pain to bring down inflation. However, there is a major difference between the early 1980s and today’s economic environment. Paul Volcker had no choice but to engineer a deep recession to bring down inflation expectations. Jay Powell does not need to engineer a deep recession because long-term inflation expectations remain well anchored. The Treasury Inflation Protected Securities (TIPS) market suggests that inflation could fall close to 2% by the end of 2023.
We think the Fed will have an opportunity to at least pause its current hawkish policy while the economy digests higher interest rates. Our take is that the U.S. and the global economy will be able to live with higher rates. One sign of this is that in December, U.S. firms once again hired over 200,000 new workers – more than pre-COVID. However, that is slower than the pace earlier in the year – and a significant part of the hiring is spreading the work as the work week ticked down to 34.3 hours. Hours worked in the fourth quarter grew at just a 0.9% annual rate, down sharply from the 2.5% pace in the third quarter.
With a shorter work week in both November and December, hours worked actually fell at a 1.5% annual rate during those two months. This largely reflects technology layoffs – where we expect workers will quickly find new jobs – and less hiring than normal during the holidays. Nonetheless, firms are clearly reducing hiring as they right size their workforce. Meanwhile, economic growth has picked up steadily over the same four quarters. The economy slumped -1.6% in the first quarter, -0.9% in the second, grew 3.2% in the third – and the Atlanta Fed’s GDPNow is at 3.8% for the fourth quarter.
The result is that after a sharp drop in productivity during the first quarter, it has steadily improved through the year, as it typically does when businesses are correcting compensation excesses during recessions and the early phases of recovery. Moreover, though wage growth has slowed a bit in line with inflation, unit labor costs have slowed much faster due to productivity growth. This in turn will support corporate profit margins.
Even if the U.S. economy does experience a recession, it will be a very mild one, owing to the fact that there is neither a major glut of homes, as there was in 2008, nor a major glut of capital equipment, as there was in 2000. Meanwhile, growth in the rest of the world is turning the corner. Economic sentiment in the Euro area is improving, driven by falling gas prices. China’s reopening, along with increased stimulus and more market-friendly policies, will also spur growth.
China: That Changed Fast
Last month, China made a 180-degree turn in its public health policy by almost entirely abandoning its dynamic zero-Covid policy. Now, there are only some nominal restrictions left, while the most economically crippling measures – quarantines, community lockdowns, and travel restrictions – have been completely thrown out the window. Beijing has finally realized that it was fighting an endless war that was rapidly losing public support. In addition, the financial cost of maintaining the zero-Covid policy has become prohibitively high.
While reliable data is hard to come by, anecdotal evidence suggests that after a tidal wave of infections, the number of new cases in Beijing and several other major cities is already declining. Consistent with this, transport and traffic data are improving, implying that China will follow the path of reopening of other countries.
At the same time, the Chinese government also completely changed its policy towards the property sector and is now launching a series of policy initiatives, including credit injection, to support and stimulate the real estate sector. Goldman Sachs estimates that the zero-Covid policy has reduced Chinese GDP by 4-to-5 percentage points. Given that China accounts for one-fifth of global output, the reversal of Covid-Zero combined with economic stimulus could raise global GDP by as much as one percentage point, a growth dividend that is currently not incorporated in the current consensus GDP forecasts.
Europe: Light at the End of the Tunnel
The European Central Bank (ECB) is facing a worse situation than the Fed because high inflation in Europe is mostly caused by the energy crunch and the Russia-Ukraine war. The central bank faces the impossible task of containing inflation while supporting a fragile economy. Nevertheless, the evidence is that the Eurozone has been unusually resilient since the onset of the Russia-Ukraine war. Although Eurozone consumer confidence has collapsed, GDP growth has fared better than the U.S. since early 2022. Of course, this is no guarantee that Europe will not fall into a recession, but if it does, we think it will also be a relatively mild one from which the European economy could recover quickly.
The advantage for Europe is that the ECB has been slow in raising rates, and Eurozone yields are significantly lower than that of the U.S. At the same time, electricity and natural gas prices have fallen sharply in recent months in Europe, which is positive for economic growth. This is partly due to warm winter weather, but also due to the uncharacteristic haste with which Europe is moving to replace Russian gas. Germany completed the construction of its first floating LNG terminal last month. A total of five such floating units are planned to be operational by the end of 2023. New pipelines are being constructed. Just last month, gas started flowing from Norway to Poland.
Last but not least, fiscal policy is helping matters substantially. European governments have announced €700 billion (4% of GDP) in income support measures for households and businesses. In Germany, the subsidies are as high as 7% of GDP.
Stocks climb a wall of worry” is a well-worn cliché, but investors’ fears have always been shifting. A few months ago, financial markets feared inflation and the continued rise in interest rates. In recent months, that fear has shifted to recession. The bearish camp says that the recent fall in stocks has been caused by multiples compression and the next down leg in prices will be led by an earnings recession. We believe stocks might already have found a bottom between June and October and the path of least resistance for stock prices is up for 2023. Of course, the path toward higher prices will be volatile. The key argument is that we think that corporate earnings and profit margins will hold up much better than the market thinks, and secondly that the 20% drop in valuations last year has already discounted a major drop in earnings.
But what if the U.S. faces a recession this year? Has the U.S. equity market already discounted a potential recession? Most investors would say no, but we think it has. Historically, a multiples contraction of anywhere between 20-25% has always predicted or coincided with recession. History shows that if a bear market in stocks is induced by high inflation and Fed monetary tightening, an end to the bear market usually comes once the Fed finishes monetary tightening, while inflation starts falling, regardless of whether recession follows.
We suspect that the U.S. stock market might have started a new bull market, but price advances will continue to be volatile and hesitant in the early part of 2023. The Fed cannot declare victory over inflation and tight policy will be maintained in the coming few months. In the meantime, the risk of recession will continue to rise, clouding the earnings outlook, which will cause stock price volatility.
In the coming months, bull market fundamentals will likely reassert themselves with force: the trend of disinflation should become clear by then, the economy should have slowed, and wage pressure would ease. The Fed will be much less hawkish and financial markets would start to discount lower rates, particularly if the U.S. economy is in a recession. This would all support the stock market.
Improving economic growth globally means that international equities could outperform the U.S. market, after more than a decade of U.S. outperformance. The key reasons are that the U.S. equity market is much more expensive than its international counterparts. Secondly, the dollar will likely weaken in 2023 and the U.S. equity market tends to underperform the global benchmark whenever the dollar depreciates. The bottom line is that international equities hold the potential to deliver better-than-average returns. Given the fast turn of events in China, we also like Chinese stocks from a cyclical viewpoint.
Slowing growth, falling inflation and a change in central bank policies, make it more likely than not that bond yields will fall. Since their peak in November, 10-Year Treasury yields have already come down significantly. We think that fixed income is more attractive than it has been in many years. Even if growth surprises to the upside and yields rise from the current level, the current yield provides a decent buffer for bond price movements. We think we could see an environment that is the opposite of last year. In other words, we could see a scenario in which both bonds and equity markets will generate positive returns. Within fixed income we continue to like high grade corporate bonds as well as private credit for those investors whose portfolios are suitable for lower liquidity exposures. As we think the U.S. dollar could weaken more, we like emerging market government bonds both for their high yield and upside potential.
A Weaker Dollar
The U.S. dollar’s yield advantage versus other major currencies has likely peaked and is likely to narrow in 2023. If the Fed would actually cut rates, then the narrowing in interest rate differentials should be even steeper. Forex markets usually anticipate a peak in the Fed policy rate, as exemplified by the U.S. dollar downturn already underway. Adding to the dollar’s woes will be a rebound in Chinese growth.
We are bullish on commodities and gold for 2023. This may sound counterintuitive because slowing economic growth or a potential recession is usually bearish for commodities, but economic growth from Asia will likely offset expected economic weakness in the West. China’s economic reopening and policy easing is likely to be bullish for commodity prices. In addition, oil and industrial metals have already fallen sharply from their perspective tops and the magnitude of decline is comparable to the drop in past recessions. As such, the broad economic backdrop may not necessarily be bearish for industrial commodities.
Beyond improved economic growth, there are several additional bullish factors for commodities and gold. Capital investment in the global mining sector has been very weak for years, reducing productive capacity. A strong revival in commodity demand can easily boost prices. And though it’s easy to almost forget about it, the transition towards electric vehicles and green energy generation is not only in full force but accelerating, requiring substantial increases in industrial metal supply.
In the past few months, our outlook has slowly become more positive and we have repositioned portfolios for a rebound in markets. In the past month, the overweights in China, Japan and in commodities have helped our core equity portfolio performance.
The fixed income portfolio outperformed strongly in 2022 as we held shorter duration bonds in the first half of the year and increased duration and credit exposure in the second half of the year, which was the right decision. However, the outperformance happened in a strongly negative year for fixed income.
We continue to have a balanced approach in portfolios with a slight tilt to risk as we are taking a more positive view on risk assets for 2023.
DISCLAIMERS & DEFINITIONS
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to the accuracy, completeness, or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.
The Bloomberg Barclays US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the US bond market.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value-weighted index with each stock’s weight in the index proportionate to its market value.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.