2023 Investment Outlook: A Volatile, Asymmetrical Year in a Recessionary World
2022 was an annus horribilis* for global investors and financial markets; trillions of dollars were wiped off from global equity markets, with S&P500 seeing its worst annual performance since 2008, historic sell-off in bond markets, wild swings in Commodity & FX markets and collapsing crypto empire.
The biggest driver of this was multi-decade high inflation, forcing global central banks to deliver rate hikes at the fastest and biggest scale in two decades. Investors also had to grapple with geopolitical turmoil, leading to massive energy and food price spikes.
In our view, the real issue plaguing the global markets, in the long run, is the financial leverage and excessive debt accumulated since the 2008 global financial crisis. Debt’s sustainability depends on low-interest rates and a low-inflation environment. Post GFC (Global Financial Crisis) era was characterized by low inflation, low-interest rates/ massive monetary interventions, which led to a secular bull run and distorted financial markets from their respective underlying economic linkages.
As the inflation playbook changed from low to multi-decade high, central banks were left with no choice but to step away from the backstop they had provided in the last decade and took a sharp U-turn on the projected interest rate trajectory, leaving investors with unsustainable levels of debt/financial leverage.
Unfortunately, after the longest bull market in history, most investors had also become complacent in expecting elevated rates of return from the financial markets and developed rationalizations to justify overpaying for assets. However, the problem is that replicating those returns becomes highly improbable in a low growth high, inflation world unless the central banks and governments re-commit to fiscal and monetary interventions.
*annus horribilis: A year of disaster or misfortune
Considering our outlook for the year, let’s ask some basic questions and ponder on how asymmetric 2023 could be.
- Can the markets build on gains seen in October & November last year (2022)?
The answer is yes, given the consensus bearish view, market positioning, and investors’ propensity to give more weight to incoming soft economic data and therefore expecting a FED pivot sooner than later. As a result, we believe that, quite likely, Jan’23/Feb’23 can turn out to be a hugely positive month for markets, with U.S. indices returning 5-10% gains.
- Can the bear market resume and markets correct significantly?
The answer is yes. In our view, Initial euphoria won’t last long, and markets would correct considerably thereafter as none of the factors that led to the market decline last year (elevated inflation, sharply higher interest rates, geopolitical turmoil) is resolved, adding to that a potential recession and earnings decline. Our bias remains that in the first half of 2023:
- The Federal Reserve will continue to raise interest rates, higher than the market currently expects. Rates would stay elevated until inflation is on a persistent downward path towards FOMC’s 2 per cent objective.
- US yields will trend higher still, and curves will invert further (2’s 5’s in particular).
- US equities will remain under pressure and witness declines in high teens during the year.
Recession in the U.S. is foretold, and a potential liquidity crisis is looming large over the markets. We believe that 2023 will be accompanied by high volatility and wild swings, with many false rallies within a large bear market, given the huge disconnect between investors’ expectations and what the U.S. Federal Reserve is trying to achieve and communicate.
Recommendation to investors on Portfolio Construction with focus on quality and income generation rather than on growth…
We recommend investors construct portfolios with a focus on quality and income generation rather than on growth. Our preference is for Investment Grade fixed income, High quality dividend stocks with low earnings variability and low debt-to-equity, and healthy cash allocation. For portfolios with existing equity allocation, consider buying protection.
Against this backdrop, we recommend investors to construct portfolios with focus on quality and income generation rather than on growth. Our preference is for Investment Grade fixed income, High quality dividend stocks with low earnings variability and low debt-to-equity, and healthy cash allocation. For portfolios with existing equity allocation, consider buying protection.
- Cash is providing attractive risk-free yields in current markets.
- Core investments should be kept separate from trading opportunities.
- Go up in quality at the expense of returns and look for value in the chaos.
- Know that you have the resources to weather a crisis. Remember, downturns don’t last forever but it is important to survive them.
“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioural discipline that are likely to get you where you want to go.” – Benjamin Graham
Reflection on 2022
Global Markets, Stubbornly High Inflation, Sharply Higher Global Interest Rates, Series of Crypto Meltdowns, Geopolitical Fragmentation, Slower Growth in the US, Europe & China, Europe energy crisis, Asset Performance…
- Global markets absorbed a never before the magnitude of macro & geopolitical shocks in 2022.
- Stubbornly High Inflation with the annual inflation rate in the US highest since 1981; double-digit inflation for the first time in Euro Zone; 4 in 10 countries in the world are currently experiencing double-digit inflation
- Sharply Higher Global Interest Rates: the most aggressive pace of monetary policy tightening by the US Federal since the early 1980s; 275+ rate hikes globally, enough for one every trading day, with just 13 cuts; More than 50 central banks executed once-rare 75 bps increases, some joining the Fed in doing so repeatedly.
- Series of Crypto Meltdowns: Collapse of TerraUSD and LUNA in May; Multiple Bankruptcies Filing – Celsius Network, Three Arrows Capital, Voyager Digital, FTX and FTX.US, BlockFi; Steep Fall in Market Cap – Total value of the largest 100 cryptocurrencies dropped 70%
- Geopolitical Fragmentation: Largest conflict in Europe since World War II and Unprecedented sanctions against Russia by U.S. & EU
- Slower Growth in US, Europe & China: The outlook for U.S. real GDP growth worsened over the past year; the European economy continued to take the hit as the year progressed amid elevated uncertainty and high energy price pressures; China’s economy is expected to have grown by 2.8% in 2022, well short of the official target of ~5.5% and compared to 8.4% in 2021.
- Europe energy crisis: European energy prices hit all-time highs in 2022; Energy costs for households across Europe nearly doubled compared to a year ago.
- Asset Performance: The worst year in decades for both equity and fixed income markets; S&P 500 saw its biggest annual decline since 2008; Bloomberg’s index of US Treasuries posted its worst annual performance since data began in 1973; US Dollar index touched a 20-year high, and Commodity prices rose to multi-year highs
All MSCI world sectors except ‘Energy’ delivered negative total returns.
Investing Lessons from 2022
- Stocks and Bonds can Fall at the same time
- Buying the Dip strategy doesn’t always work
- Mega Cap Tech Stocks aren’t immune from downturns
- Valuations always matter in the end
- Gold isn’t always an Inflation Hedge; neither is Bitcoin
- Avoid concentration, Right-size positions
We see 2023 as an asymmetrical year segmented between the first few weeks of market euphoria of sooner-than-expected FED pivot, the next several months and quarters of bear market on the harsh realization that FED is not exiting prematurely and a strong last quarter on a more supportive backdrop for financial markets.
Elevated Inflation: Tightness in labour market, risks of the wage-price spiral, ageing population and shrinking workforce are leading to inflationary pressures. We believe that the worst on inflation is behind us, but it will remain elevated for some time.
Higher U.S. Interest Rates but at a slower pace: We expect the U.S. Federal Reserve to continue to tighten until the Federal Funds rate exceeds headline inflation. We forecast the policy rate to peak around 5.25-5.50% by mid-2023, followed by a pause in 3rd quarter and a small rate cut in Q4 2023/Q1 2024.
Severe Slowdown in Global Growth: Global policymakers have gone all out in the battle to contain surging inflation and ramped up interest rates. The full effects of higher rates take 12-18 months to come through; therefore, we expect a severe slowdown in global growth in 2023. The US, Eurozone and UK should witness recessions, and the rest of the world should continue to weaken. However, the end of the zero covid policy and proactive fiscal as well as monetary policy support should provide a much-needed boost to the Chinese economy.
As a result of Elevated Inflation, Higher Rates for longer, Slower growth, Risks of liquidity crisis and a complex Geopolitical backdrop, we expect that the bear market will resume in the U.S. in the first half of 2023.
Evidence that headline inflation is below policy rates, an end to Fed rate hikes, and anticipation of potential interest rate cuts/Fed Pivot would mean that a more constructive environment for risk assets should start to emerge before the end of 2023.
Many factors may contribute to inflation; elevated wage growth, tightness in labour markets with historically low unemployment and a high ratio of job openings per unemployed person.
Ageing populations mean continued worker shortages in many major economies, a long-term trend which is keeping production capacity constrained and feeding into inflationary pressures. A shortfall of immigrants in the U.S. is also worsening the labour shortage, hence adding to wage pressures.
Geopolitical fragmentation is rewiring globalization, and economic nationalism is forcing manufacturers to increase domestic production as well as source supplies from closer to home, even if this means higher prices.
Against this backdrop, central banks have responded by sharply raising interest rates to levels that would damage economic activity and crush demand. This has already resulted in yield curve inversion and money supply contraction, a precursor to recession.
We believe that the worst of inflation is behind us, but it will be harder to bring down to the desired level of around 2%, given the long-term trends in play. Energy prices should relent on demand destruction and inventory buildup amid a global economic slowdown. As spending patterns normalize and energy prices correct, inflation will likely cool down from abnormally high levels but would stay well above the FOMC target.
As we enter 2023, fears of persistently high inflation have somewhat receded, and the focus shifts to recession risks and the implications for profits. Weakening demand alongside strong wage growth and rising rates is a toxic combination for profits. Incoming earnings seasons, therefore, would be marked by declining EPS, job cuts and pressure on share prices.
But the real danger to risk assets and equities is the double whammy of a recession and a liquidity crisis. Cumulative tightening with near 5% rates and $95 billion a month in quantitative tightening has the potential to implode the asset bubbles built on prolonged near-zero interest rates and $120 billion/month in quantitative easing. With central banks hiking rates and shrinking their balance sheets and many investors shifting into cash, liquidity was withdrawn rapidly in 2022. Another sign pointing to a potential liquidity crisis is the sharp declines in the dollar-denominated reserve positions in U.S. Treasury securities held by China, Japan, and other economies such as Switzerland, France, Taiwan, Korea, Hong Kong and Ireland. Markets function best when there’s plenty of liquidity. Liquidity loss not only adds uncertainty into markets but could also destabilize financial markets.
The question now is how much of the future economic & financial damage is already priced in? We believe the equity valuations don’t fully reflect the damage ahead. Assuming an unlikely 15% growth in S&P 500 GAAP for Q4 2022, the EPS annualizes to $184.21. A generous 17x multiple on that—for a rising rate, recessionary environment brings the S&P 500 down to 3132 vs. 2022 close level of 3839 (18.40% lower). Therefore, we have a pessimistic outlook for first 3 quarters of 2023, targeting 3000-3200 range for S&P500 and 7500-8200 range for Nasdaq Composite.
We might turn positive on U.S. equities when we think the damage is priced in or something critical breaks during the year and FED is forced to pivot. We recommend investors to align their portfolios towards income-generating strategies and avoid growth trap in a high-interest rate recessionary environment. Therefore, we like quality dividend stocks—companies with a high return on equity, low earnings variability, and low debt-to-equity. Investors should also consider buying protection for their existing equity positions.
Within sectors, we recommend avoiding mega tech & discretionary names. Our preference is for utilities and consumer staples which are typically less volatile and have a history of outperformance during periods of economic decline, healthcare with appealing valuations, likely cashflow resilience during downturns and Financials, benefiting from higher interest rates.
Contrary to consensus, our preference is for Europe, including Swiss and UK equities; all of which are attractively valued. We believe that US dollar has already seen its best and should convincingly change direction in second half of the year. Emerging-market equities typically outperform once a dollar bear market enters the scene. That should brighten the relative outlook for both emerging markets and European risk assets.
China will be one of the few economies where growth in 2023 will be better than in 2022. Re-opening trade should continue to benefit HK/China, this coupled with further policy/liquidity support, hopes of a stabilization in the housing market, attractive valuations and EPS growth make it attractive. Within Emerging Markets, we like Brazil with attractive valuations and benefiting from easing cycle ahead, South Korea benefiting from China opening and Qatar which is positioning itself as new investment and business hub in middle east and launching new mega projects. Qatar has also maneuvered effectively and extended its Natural Gas dominance by becoming indispensable energy supplier to Europe at Russia’s Expense.
Fixed Income Outlook
Return of inflation has fundamentally altered the asset allocation landscape as the risk-return in fixed income has become more favorable after the sharp move higher in global interest rates. The opportunity to earn more predictable returns is appealing against an uncertain backdrop. We suggest entering the year with a defensive allocation, preferring fixed income to equities, and keeping a healthy allocation to cash. We are overweight shorter duration investment grade corporate bonds which currently provide the highest yields seen for years and are relatively insulated from an economic downturn given the strong balance sheets. We advise clients to avoid longer dated government bonds and perpetuals. With low global growth, record sovereign debt levels and inflation is likely to stay elevated; investors would demand higher compensation for holding them. Duration would start to trade well once the rate cuts come into play.
In currencies, we believe that U.S. Dollar has seen its best already, but it will strengthen in the first half as risk assets nosedive resulting into greenback recovering some ground it lost in recent months. A broad turn in the dollar would eventually come when Fed stops hiking interest rates. We believe that developed market currencies are now undervalued and would stage a turnaround and appreciate in second half. By end of the year, we expect a considerable weaker dollar from current levels with EUR at 1.13-1.15, GBP 1.28-1.30 and JPY at 116-118 range. Slower US growth and China reopening should provide a positive backdrop to commodity-linked currencies especially AUD and NZD. We expect antipodeans to strengthen to 0.75 and 0.70, respectively against the U.S. Dollar. Within Emerging markets, we like Korean Won and Brazilian Real.
Oil Price Outlook
Dominant theme for Oil market in 2023 is likely to be demand destruction and inventory buildup amid global economic slowdown. Any rebound in oil demand in China, the world’s top crude importer, on hopes of a rapid recovery of the Chinese economy would be more than offset by drop in demand in rest of the world due to economic slowdown. While the Chinese stock markets could react more positively to the policy support, the actual economic recovery (and hence the pickup in Oil demand) faces several headwinds after three years of Zero covid policy; the mass bankruptcy of small and medium-sized enterprises, the soaring unemployment rate, rattled consumers, who have been saving heavily amid the uncertainty and the loss of jobs and businesses. Historically, after large oil price shocks like the one that came in early 2022, the price of oil tends to fall substantially over the next one to two years. We therefore foresee oil prices coming under pressure and WTI trading as low as $50-60 during the year.
Central banks are reassessing their foreign exchange reserve composition. U.S. dollar weight in foreign exchange reserves has fallen to around 60% from 71% at the turn of the century. Global central bank gold reserves is now back to mid-1970s levels. Data compiled by the World Gold Council, has shown that gold purchases by central banks in 2022 were the highest since 1967. We believe that the current fractured geopolitical environment, one of mistrust, growing reluctance to rely heavily on U.S. dollar, significant central bank losses resulting from falling bond prices and rotation of crypto money into yellow metal would lead to significant demand, thus providing support to Gold prices over coming years. If the price is abl>e to break above $2,030, the long-term target (which could materialize over next 4-6 years) is $2,700-3,000. However, in the medium term (next 3-6 months) we will not be surprised to see a retest of bottom of handle near $1,600 levels. We advise buying Gold on dips with a long-term bullish outlook, targeting $2,700-3,000.
RECAP – A Volatile, Asymmetrical Year in a recessionary world
Investors must prepare for a tough year and expect many false rallies within a large bear market.
We recommend investors to construct portfolios with focus on quality and income generation rather than on growth. Our preference is for Investment Grade fixed income, High quality dividend stocks with low earnings variability and low debt-to-equity, along with healthy allocation to cash. Investors should consider buying protection for their existing equity positions.
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