Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

There is a Winston Churchill quote for every occasion, and the one that fits current market conditions is: “if you are going through hell, keep going”. It’s been a hellish year for investors with almost every major listed asset class posting negative returns. The rebound over the past couple of months has provided investors with some relief, but it’s too early to be confident that we have seen the worst.

The economic news is likely to deteriorate. Europe and the UK are probably in recession, and a mild recession at least seems likely for the United States given the extent of monetary tightening. It’s unclear when China can fully escape zero-tolerance Covid-19 lockdowns and the property-market implosion. The exception as always is Japan, which hasn’t had monetary tightening and where the inflation spike offers the opportunity to break nearly three decades of deflationary psychology.  

Markets, of course, are forward looking and usually price in bad economic outcomes ahead of time. It’s possible that we’ve already seen the worst declines in equity markets. This may be the case if the U.S. has only a mild recession in 2023. On the other hand, markets may transition from the current ‘bad news is good’ narrative that sees soft economic data as heralding a U.S. Federal Reserve (Fed) pivot, to a ‘bad news is bad’ scenario wherein fears of significant contraction in profits and jobs lead to further market downturns.

Will inflation ease in 2023?

The main issue for 2023 is whether inflation pressures ease sufficiently to allow central banks to step away from rate hikes and potentially begin easing. We expect inflation will be on a downward trend as global demand slows. This should allow central banks to eventually change direction and may set the scene for the next economic upswing. Markets and economies move in cycles. There is no certainty that we have passed the worst of market conditions, but the contours of the next upswing are visible on the horizon. The beaten-down investors of 2022 in Churchill’s words need to keep going into 2023.  

Our key asset-class views for 2023:

• Fixed income will make a comeback after experiencing the worst year of returns in 2022.
• Long-term bond yields should decline moderately as recession risk looms. Our target is 3.3% for the U.S. 10-year Treasury yield by the end of 2023.
• Equities have limited upside with recession risk on the horizon.
• The U.S. dollar could weaken late in 2023 as central banks start to unwind rate hikes and investors begin to focus on a global recovery.
• This could be the trigger for non-U.S. developed market equities to finally outperform U.S. stocks, given their more cyclical nature and relative valuation advantage over U.S. stocks.
• A weaker U.S. dollar could also be the trigger for emerging markets to outperform.
• Overall, 2023 is likely to be the year of the diversified portfolio, where a traditional balanced portfolio of 60% equities and 40% fixed income does well.

The story of 2022 has been the energy price shock from the Russia/Ukraine war, high inflation, and large central bank rate hikes. Fed Chair Jerome Powell is on track to deliver the most aggressive Fed tightening phase since former Fed Chair Paul Volcker in the early 1980s. Market expectations are that the Fed funds rate will rise from 3.75-4.0% currently to 5% by March 2023.

The indicator that most clearly signals recession risk is the yield curve. The chart below shows the spread between the 10-year and 2-year Treasury yield. A negative spread (inversion) means bond investors think the Fed has tightened by so much that interest rates will be lower in the future.

It’s still possible that inflation and growth indicators will slow by enough over the next few months to allow the Fed to pivot away from aggressive rate hikes before the economy slides into recession. Declining inflation will boost real incomes and demand. This could allow recession to be avoided. The likelihood of this outcome, however, has diminished and the Fed pivot seems unlikely to happen in time to prevent at least a mild recession.

What type of recession could the U.S. experience?

The next issue is what type of recession is likely—moderate or severe? In the 13 recessions since World War II, gross domestic product (GDP) suffered a median decline of 2.6% and the unemployment rate rose by 3.6% points.

The risk of a severe recession comes from the speed and magnitude of Fed tightening, and how this might create unexpected problems. The UK already had a hint of this in September with the turmoil in leveraged strategies used by pension funds. This came when gilt yields rose suddenly after the disastrous mini budget by the short-lived Liz Truss government. There has also been the collapse in crypto assets. So far, the links from crypto to the traditional financial sector and broader economy appear limited, but both episodes highlight the risks of hidden leverage when interest rates are rising.

Our starting point is to expect that the next recession will be relatively mild. Household and corporate balance sheets are in good shape. Aside from inflation, there are no significant obvious economic imbalances. It’s reasonable to expect that a recession in 2023 will see GDP decline less and unemployment rise by less than the average for modern recessions.

In fact, a mild recession may be the best outcome from an investor’s perspective. A condition for sustained lower inflation is that wage pressures start to ease. The Atlanta Fed wage tracker shows wage growth of 6.7% in the year to October. The unemployment rate, at 3.7% in October, is near 50-year lows. The risk with a soft landing that avoids recession is that the unemployment rate doesn’t rise by enough to reduce inflation close to 2%. In this scenario, the Fed could go on pause early in the year, but resume tightening in late 2023 if inflation is still above its comfort zone. The Fed funds rate could then rise toward 6% and set the scene for a more significant recession and market reaction in 2024.

Under a mild recession outcome in 2023, the unemployment rate should rise by at least two percentage points, creating the type of disinflationary pressure that would allow the Fed to begin easing. 

The interest rate reset of 2022 has resulted in the worst fixed income returns on record. The global fixed income benchmark, the Bloomberg Global Aggregate Index, posted a -20.8% return for the year through October. This outstrips the previous worst 12-month return of -7% in 2015 by a wide margin.

Could the traditional 60/40 portfolio make a comeback?

The only good news from the painful fixed income adjustment is that we are finally escaping the world of TINA—there is no alternative—where ultra-low interest rates forced investors into equities and a risky search for yield. Higher  interest rates mean that TARA—there are reasonable alternatives—is now a better description of the investment opportunity set. The yield on the Bloomberg Global Aggregate Index, at 3.6% in late November, is the highest since 2009. The U.S. high yield index has a yield near 9%. UK investors can now access a yield close to 4% on the benchmark Sterling Broad Market Index.

The return of TARA signals that the traditional balanced portfolio made up of 60% equities and 40% fixed income is poised to make a comeback after its worst year in living memory.

Our cycle, value and sentiment (CVS) decision-making process points to an uncertain global equity market outlook.

When could the business cycle improve?

The cycle outlook, with recessions likely, is a headwind for equity markets. This may improve once it is apparent that the Fed has finished tightening. The turning point will come when interest rate cuts are on the horizon.

Are U.S. equities still expensive?

Equity market valuation is a question mark. The U.S. large-cap S&P 500® Index, as of late November, is 16% below its peak at the beginning of the year. The 1-year forward price-to-earnings multiple has fallen from 21.5 times at the start of the year to 17.5 times in late November, but this is still a high multiple by historic standards. Our valuation methodology is scoring U.S. equities as slightly expensive. Non-U.S. equities are close to fair value.

Is sentiment supportive?

Our composite sentiment indicator for equities is only marginally oversold as of late November. It has, however, reached extremes of pessimism twice this year. Sentiment extremes of this magnitude tend to have a persistent impact on market psychology, and we still score sentiment as supportive for equities.

The CVS conclusion for equities is that the cycle is poor but may improve, value is expensive to at best fair value, and sentiment is still supportive.

Are government bonds attractive?

Government bonds, however, are attractive from a CVS perspective. The cycle is turning supportive with inflation set to decline and central banks slowing the pace of tightening and potentially going on pause in early 2023. Value has turned positive after rises in yields this year. Sentiment is also supportive with data from the Commodity Futures Trading Commission highlighting that most investors hold short-duration positions (i.e., they expect yields to rise). This is supportive from a contrarian perspective.

Composite contrarian indicator

Source: Russell Investments. Last observation is +1.24 Standard Deviations, as of November 22, 2022. The Composite Contrarian Indicators for investor sentiment is measured in standard deviations above or below a neutral level, with positive numeric scores corresponding to signs of investor pessimism, while negative numeric scores correspond to signs of investor optimism.

Looking toward 2023, we believe:

• Equities have limited upside with recession risk on the horizon. Although non-U.S. developed equities are cheaper than U.S. equities, we have a neutral preference until the Fed become less hawkish and the U.S. dollar weakens.
• Emerging market equities could recover if there is significant China stimulus, the Fed slows the pace of tightening, energy prices subside, and the U.S. dollar weakens. For now, a neutral stance is warranted.
• High yield and investment grade credit spreads are near their long-term averages, although the overall yield on U.S. high yield at near 8.5% is attractive. Spreads will come under upward pressure if U.S. recession probabilities increase and there are fears of rising defaults. We have a neutral outlook on credit markets.
• Government bond valuations have improved after the rise in yields. U.S., UK and German bonds offer good value. Japanese bonds are still expensive with the Bank of Japan defending the 25-basis-point yield limit. Our methodology has fair value for Japanese government bond yields at around 50 basis points. Yields have risen sharply in most markets in recent months. The risk of a further significant selloff seems limited given inflation is close to peaking and markets have priced hawkish outlooks for most central banks.
• Real assets: Real-estate investment trusts (REITs) look attractively valued relative to global equities and listed infrastructure and should benefit from declining bond yields. The commodities outlook is mixed, given the expected slowdown in the global economy. A post-lockdown increase in construction activity in China next year will support demand for industrial metals. The energy market outlook is complex. Recessions will reduce oil demand, but the supply side may tighten if more restrictions are placed on Russian oil exports.
• The U.S. dollar has made gains this year on Fed hawkishness and safe-haven appeal during the Russia/Ukraine conflict. It could weaken if inflation begins to decline and the Fed pivots to a less hawkish stance in early 2023. The main beneficiaries are likely to be the euro and the Japanese yen. The yen could also appreciate strongly if the successor to BoJ Governor Kuroda moves away from the current yield-curve control strategy.