As January Goes, So Goes the Year
February 9, 2023
Harmen Overdijk, CFA, Chief Investment Officer
There is an old Wall Street saying: ‘As January goes, so goes the year’. If that holds true, we are off to a good start. We started the year on a positive note with equity markets, bond markets, and commodities all generating positive returns. Asian equity markets especially showed strong performance. At the same time, the U.S. dollar and energy prices weakened. The past month’s performance was a mirror image of how markets behaved last year.
The combination of falling inflation, better-than-expected economic growth, and lower equity valuations alongside a less aggressive monetary policy creates a short-term ‘Goldilocks scenario’ that could be quite positive for risk assets in the coming months. A goldilocks scenario is when all factors are moving in the right direction. We might currently be in that situation when inflation pressures are clearly receding while economic growth, although softening, is still holding up nicely. Property and employment markets are softening but not crashing. This allows central banks to start softening their hawkish monetary policy by raising rates in smaller steps and potentially even pausing raising rates soon. Combine all this with lower equity market valuations and reduced earnings expectations and we have an environment in which equity markets could keep rising.
A key reason for the equity and bond market sell-off last year was the fear that rising inflation would lead to much higher interest rates, which eventually would lead to a deep recession. That fear is now receding and slowly giving way to a more optimistic outlook.
A Pause Before the Pivot
During the recent FOMC meeting, chair Jay Powell sent some reassuring signals to investors, noting during his press conference that the risk of a wage-price spiral has become “less salient” as inflation has fallen. He downplayed the recent easing in financial conditions and said that the Fed intends to hike rates only a “couple more” times before pausing. When asked why, in contrast to market expectations, the Fed dot plot foresees no rate cuts this year, Powell answered that investors think that inflation will fall faster than the Fed believes. He then nudged open the door to the possibility of pre-emptive rate cuts, saying that “if we do see inflation coming down much more quickly, that will play into our policy setting, of course.” Powell’s comments were well received, and equity markets rallied nicely after the Fed meeting. However, markets remain volatile, and sentiment changes daily in reaction to short-term news.
The main trends are still in place. Headline inflation will come down sharply in the coming months, while economic growth will stay reasonably strong. That is also visible in the strong U.S. employment data released last week. Therefore, the Fed is unlikely to cut interest rates this year. A more likely scenario is that the Fed pauses rate hikes but does not pivot as we do not think that a recession is imminent. The only reason for the Fed to start cutting rates is when the economy falls into recession. This could happen, and eventually will, but we do not think it will happen in 2023.
January’s unexpectedly strong U.S. jobs data supports our view that the U.S. economy is in better shape than many investors were forecasting two months ago. Eventually, U.S. economic growth will weaken on tighter financial conditions, but we think a recession is not likely before 2024.
In recent comments, Powell highlighted that labor market resilience reinforces the Fed’s expectation that it will take time for inflation to return to the 2% target. Powell reiterated that although he expects inflationary pressures to decline significantly this year, the process is still in an early phase. The path down for core services excluding housing inflation is particularly uncertain and is the basis for the Fed’s assessment that ongoing rate hikes will be appropriate and that there is a need to keep policy restrictive “for some time.” Moreover, Powell cited the war in Ukraine and China’s reopening as risks to the inflation outlook.
Notably, Powell underscored that incoming data will ultimately guide Fed policy. He noted that persistently elevated inflation or tight labor market conditions could lead to more hikes than what is currently priced into financial markets. The risk is that Fed policymakers become stubborn, refusing to recognize the fact that inflation is headed down and continuing to push rates higher than what is discounted by markets. If economic growth instead stays strong, it is possible we could see rising inflation again in the second half of the year, which will impact the Fed’s policy the other way.
Other central banks are also already indicating a potential end to the rate-raising cycle. The ECB raised its three policy rates by 50bps in the February meeting and signaled that it intends to raise interest rates by another 50bps at the next meeting in March. That said, the underlying signal is that the ECB is nearing the end of the tightening cycle. Back in December, Lagarde noted the possibility of three more 50bp rate hikes. However, since then inflation has been falling faster than anticipated, implying that there may not be a need to tighten policy much further.
The preliminary Q4 GDP estimate suggests that the Euro Area economy expanded by 0.1% in the last quarter, beating expectations of a 0.1% contraction. The improving energy situation due to milder-than-anticipated weather, as well as generous fiscal support measures, contributed to the region’s economic resilience and led to an annual 3.5% GDP growth in 2022. So, even in Europe, we see a potential goldilocks scenario unfolding.
If the Fed manages to cool the U.S. economy and reacts quickly to any recessionary signs, even if we see a mild recession, it would still be considered a soft landing. This would be a great outcome for equity and credit markets. The main risk is the Fed may waste an opportunity to soft-land the economy, potentially depressing stock prices.
The question is, should investors hedge the risk of the Fed making a policy mistake? It is better to stay invested in equity markets as Fed policy can change on a dime, causing stocks to rally. In the meantime, the equity market selloff last year has already created value, particularly with the S&P 494 (the S&P 500 Index excluding the top 6 mega-stocks) currently trading at 16 times forward earnings per share. This is a reasonable valuation when economic growth is still decent, and inflation is falling.
The equity sell-off last year reflected both a profit margin squeeze and lower earnings multiples driven by a hawkish Fed and upward pressure on costs. The good news is that these trends will bring Fed easing nearer and cost pressures should ease as 2023 progresses.
After a turbulent year of zero-covid restrictions and a weakening economy, the Chinese government is prioritizing growth protection. The Chinese economy will almost certainly recover strongly in 2023, with high odds of positive surprises. This is a key reason for our bullish stance on Asian and Chinese equities. Currently, consensus expects about 5% GDP growth in China for 2023, and we see the potential for further upside.
Some senior U.S. military officials and politicians have recently publicly warned that a war with China could erupt as soon as 2025, a notable escalation of hawkish comments out of Washington. While a military conflict cannot be ruled out, the risk of a war over the Taiwan Strait is low in our view, and a comparison with the Russia-Ukraine situation is misguided. If anything, the Russia-Ukraine war has made it less likely for Beijing to engage in direct military action against Taiwan.
The Adani Affair
Recently the multinational Adani conglomerate made news headlines as it was targeted by U.S. short-seller Hindenburg Research and subsequently lost USD 100 billion in market value. Adani owns diverse businesses, including port management, electric power generation/transmission, renewable energy, mining, airport operation, natural gas, food processing, and infrastructure. Hindenberg Research’s report questioned Adani’s accounting practices, offshore shell corporations, related family member board seats, and high debt owned by insiders and made many other allegations. All things considered, the Indian stock market has held up relatively well, dropping only 5% over the last 2 weeks versus circa 50% for the Adani group.
So why does this matter? The Adani saga is precisely the reason India has remained underinvested by many international portfolios. The opportunity is substantial, but so is the opaqueness and potential for fraud. The fact that nationalist sentiment is the most visible defense so far and that no public investigations have been announced does not inspire confidence. Our portfolios have minimal exposure to India, and thus we do not expect to have any impact.
For the first time in years, we are more positive about holding fixed income as part of a portfolio allocation. The reason we did not like bonds for the last few years was that the risk-return equation had become asymmetric with a lot of downsides and little upside. Unfortunately, that was exactly the scenario that played out in 2022.
After the substantial rise in yields, the situation is very different now. Although 10-Year U.S. Treasury yields have come down from recent highs of 4.6% to around 3.6%, fixed income as an asset class remains attractive. The reason is that the risk-return trade-off is once again symmetric, which means that bonds can provide downside protection in case of a major economic setback. Treasuries have limited downside, even in relatively optimistic economic scenarios, but considerable upside in a recessionary scenario.
For the next 6 to 12 months, we are neutral on a fixed income as we do not believe that the Fed will cut rates soon, even though the market is discounting that. If a recession is not imminent, the yield pick-up on higher quality high yield bonds and U.S. private credit is still particularly attractive.
We remain bullish on commodities and gold for 2023. Recently we have seen pronounced weakness in energy prices and given the reopening of China, we expect demand for oil to increase. There are geopolitical risks that could impact the oil price as the Russia-Ukraine war is still ongoing and Iran remains a major risk factor in the Middle East.
We have also seen a big divergence between oil and copper prices. While copper prices have risen 36% since last summer, oil has fallen by 22% over the same period. If economic growth holds up, we can see a relative rebound in energy prices.
We had positioned our portfolios for a rebound in risk assets into the new year. Our overweight of the NASAQ and Chinese equities helped portfolios in January. As we expect markets to remain volatile this year, we continue to favor a balanced approach or quality and growth exposure.
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