End of year wrap up
Posted 19 December 2022
A year of volatility draws to a close
We saw broad and deep losses across asset classes in 2022, as investors feared slowing global growth and priced in sharply tighter monetary policy. Sky-high inflation forced interest rate hikes at the quickest pace in a generation, while business sentiment soured across major economies. Rising bond yields drained markets of their liquidity and made equities less attractive by comparison, leading to sporadic but persistent falls in stock markets. Even with a late rally into December, the MSCI All-Country World index is down around 9% in 2022 (in Sterling net total return terms, London close 16th December).
Supply side problems were the big story as 2022 started. The post-pandemic burst of demand met disrupted global supply chains, sending inflation to its highest level in decades. Some of those pressure are now fading while higher prices reduce demand. The fading of supply-side problems does not mean that inflation becomes yesterday’s problem. Central banks are still extremely worried about inflation, and are likely to keep interest rates high even while price pressures lose steam. As expected, many major central banks raised rates last week and said they had more to do next year. Leaving the inflation concerns to one side, the global economy, in aggregate, saw a marked slowing of growth in 2022 but not an imminent recession. In 2023 the world may be faced with that reality. But a demonstrably positive turn in asset values will probably happen before the economic recovery blooms. Markets front-run the underlying economy, which is why we had such heavy losses earlier this year despite the global economy bumping along fairly well. In acute awareness of this, investors have for months been pre-occupied by the twin peaks – peaking inflation and interest rates – and have scoured the data for signs that the world’s central banks might be about to loosen their grip. In China, the marked slowing of growth has led to an easier monetary regime domestically, but the mechanisms for that to spread out from China are not there.
Meanwhile, sky-high inflation in Europe has kept both the European Central Bank (ECB) and the Bank of England (BoE) on a tightening path despite clear signals that real economies had slipped to stagnation or worse as the winter started. The last act of 2022 has seen an interesting divergence between the UK and Europe. The hawkish surprise was that the ECB’s economic research staff put in an inflation forecast substantially above expectations that is expected to guide rate setters higher in 2023 than had been anticipated. Central bankers have perhaps been Santa’s little helpers for too long and have definitely not helped Santa deliver a rally this year. They appear to have grown up and all become Scrooges. Ah well, those who have followed our thinking over the past weeks will know we are neither surprised nor shocked by this week’s market reaction to the latest rumblings from central bankers. As we said before and laid out in the 2023 Outlook that follows, things are looking up for 2023, but we are not quite out of the woods yet.
Outlook for regions
US: Despite all the talk of looming recession, layoffs and cost of living crises, the world’s largest economy is in a strong position. Indeed, this continued strength is what worries the Fed. It sees historically low unemployment as kindling and excess inflation as the match. Fed Chair Jerome Powell continues to warn about a potential wage-price spiral, and his policy committee will keep monetary policy tight until there are clear signs that the labour market has cooled.
For much of 2022, the growth disparity between the US and everywhere else sent investors piling into dollar assets. For the domestic US economy, this supported household disposable incomes as imported goods remained relatively less expensive than elsewhere. That meant demand stayed strong, and growth ploughed ahead, in spite of gloomy headlines. As the US economy has now joined the global cooling, the dollar has come off its highs and could ease further if fortunes improve elsewhere (particularly in Europe and China). But any hit to businesses or consumers will be offset by lower input-cost inflation and lately lower corporate bond yields. We are already seeing this and the trend towards falling headline inflation still has some way to go. That is a positive for short-term growth, but only worsens the Fed’s bigger problem: a structural labour shortage.
Business sentiment remains depressed, but this time they are holding on to their labour force, which raises consumer confidence. Since external pressures are fading, inflation will likely come down (in year-on-year terms at least) in the first half of 2023, while growth remains strong – for as long as lagged effects of past policy tightening don’t come through. Indeed, the main question is when households and corporates alike will have to refinance at higher costs. The longer that the real economy resists, the more markets will need to adjust their views on likely Fed policy delays. Powell would have to signal even higher interest rates but convince markets that this would avoid financial stress or unnecessary recession. Although there will be less pressure to raise rates quickly, the Fed will have to keep up the pressure on both labour and corporate profit margins – even through falling headline inflation.
In 2023, the US presidential cycle will hot up. Trump has already confirmed his intention to run in 2024 while Biden is still the most likely Democratic candidate (as the incumbent always is), but neither are particularly loved by their respective parties. The Republican party’s identity crisis will take centre stage as we head into the second half of the year, and could rock capital markets. However, the key political issue remains US-China relations. Tensions between the two largest economies have been high since Trump entered office, his trade war being effectively continued (or even accelerated) by the Biden administration. This is perhaps the biggest component of the ‘deglobalisation’ trend of recent years, which has played a big part in post-pandemic supply-side issues. While China may regain economic importance at the global stage in 2023, it is the direction of the US economy, its consumers and the Fed’s policy which will ultimately determine the global economic climate. From this perspective, the remarkable resilience the US economy has shown over 2022 bodes well for 2023, even if America faces increasing economic headwinds just at the point when they are likely to recede in Europe.
UK: Britain has had a tough year, with some of the highest inflation and lowest growth figures of any developed nation. Unfortunately, this does not look set to improve particularly in 2023. We are likely already in recession, following a 0.2% contraction in gross domestic product (GDP) over the third quarter of 2022. Growth is similarly expected to be negative for 2023 as a whole, though estimates vary of how bad it will be. The Office for Budget Responsibility (OBR) expects a 1.4% drop next year, while the BoE predicts a 1.5% fall. Worse still, the BoE thinks the recession will continue through to the first half of 2024. Despite all that gloom, UK assets look surprisingly buoyant. The FTSE 100 has rebounded strongly from its depths in October, while sterling is worth just as much in dollar terms as it was mid-summer – long before Liz Truss’ car-crash “mini” budget. Meanwhile, corporate bond yields have come significantly down from their October highs, giving companies more breathing space and improving equity valuations. Policy is a big part of this. The wildly pro-cyclical policies of Truss and Kwarteng were replaced by a much more austere public sector agenda under Rishi Sunak, even though the very substantial energy support subsidy payments remain in place.
The BoE will be pleased to see falling input prices, bringing down external pressures and hopefully getting inflation lower than its record levels currently. But just like the Fed, we do not expect falling year-on-year inflation to suddenly flip UK monetary policy. Like his US colleagues, BoE Governor Andrew Bailey is deeply concerned about tightness in Britain’s labour market, which he fears could lead to a damaging wage-price spiral. Despite all the recessionary talk, UK unemployment (the percentage of those looking for work but not currently employed) is still extremely low. Conversely though, the overall employment rate (the percentage of the total population currently in work) is still significantly below its pre-pandemic peak. This shows how much the UK labour supply has shrunk, due to the combined effects of Brexit and Covid. Britain is operating with less productive capacity than before – forcing the BoE to compress demand.
Targeted policy for boosting earnings growth is sorely needed but may not be fast enough to make a difference for 2023. Meanwhile, appeasement with Europe is extremely welcome. Rishi Sunak’s government appears much more conciliatory than recent Tory governments. This is one area where there could be genuine improvement, after years of Brexit uncertainty and hostility standing in the way of new and old trade. This should be a particular help to small cap companies. Again though, the effects may take a while to be felt, or might even be reversed if politicians need an easy scapegoat. As such, the economic benefits will likely not be felt until late 2023 or beyond.
Eurozone: Europe is set for a harsh winter, and households will feel the chill early next year as prices continue to rise at a historic pace. Many forecasters believe that the Eurozone is already in recession (though Q3 2022 data still showed a 0.3% gain in GDP). Despite this negativity, things could look much brighter come spring. It is still a big concern whether global suppliers will be willing or able to meet European energy demand (US producers have severely run down their inventories), but the short-term crunch is already fading.
This lessens the cost-push inflation Europe faces. Unlike the US and UK, the European labour market is not dangerously tight. Eurozone unemployment reached a record low in October, but at 6.5%, there is still room to manoeuvre. Nevertheless, the economic research staff at European Central Bank (ECB) surprised everybody with forecasts of a resurgence in inflation during 2023 as a consequence of second-round (wage growth) effects. While economists generally agree that there will be some feedback from wage rises, they do not see the same extent.
The reward for suffering gas prices is that the continent is no longer beholden to Russia, which should boost long-term stability. Moscow has made a clear attempt to divide European politicians over the years, and in many ways the energy crisis was a perfect opportunity to start the ‘conquer’ phase of that plan. Things have not worked out that way though, and there has been a surprising display of cohesion and solidarity across the EU. Even Italy’s new far-right government seems much less antagonistic towards Brussels than previous Italian governments, and has taken a clear stance against the Russian invasion of Ukraine. This is a good omen for the European economy – admittedly against the background that expectations for European policy co-ordination tend to be rather low. If this stability can continue, Europe will be well-placed when the next global growth cycle begins.
China: As the rest of the world slows or even suffers recession, China could have a strong year. The major caveats to this rosy view are the various political risks. Beijing’s interventionism in recent years has made many international commentators label China “un-investable”. This pessimism reached its zenith following the 20th Communist Party Congress in October, when President Xi tightened his vice-like grip on the nation, reaffirmed the zero-Covid policy and made almost no efforts to shore up economic confidence. Perversely, recent protests against China’s Covid restrictions seem to have lowered these risks. While government forces were quick to suppress any semblance of popular revolt, officials appeared to quietly recognise that the people had a point. Beijing has already laid out a path away from zero-Covid, and is likely to increase efforts in 2023.
We are yet to see any concrete improvements on reducing trade barriers, and we should not expect these any time soon. Under Biden, the US continues to impose restrictions on Chinese companies deemed to be security threats. Much of the relationship depends on US politicians, who may decide that China-bashing is a vote-winner heading into the election cycle. But on its part, China is signalling it wants reconciliation. This is good news for global investors, as US-China trade accounts for a significant chunk of global economic activity.
As ever though, China can be full of surprises. While we do not expect a flare-up of tensions over Taiwan any time soon, it always remains a risk – and the potential for western sanctions cannot be underestimated. Likewise for domestic policy, where deleveraging and social control remain fundamental goals for Beijing. Officials want growth, and are signalling they will act to support it. But there are other priorities, and policy can easily change. We expect China to do well in 2023, but any rewards will come with added risks.
Emerging Markets: Emerging Markets’ (EM) economic progress has always been mixed, and last year was a case in point. China went through a harsh slowdown, while Russia was ostracised from the international community following its invasion of Ukraine. And yet, EMs excluding China and Russia held up much better than feared. Select equity markets in Asia and Latin America (LatAm) should finish the year positively in GBP terms (Mexico, Brazil), and some even in local currency terms, such as India, Indonesia and Chile. There are several reasons why. Compared with China, other EMs did not have to deal with outright negatives such as a broken property sector, overly restrictive regulatory policy, or zero-Covid policies. Indeed, LatAm countries were at the forefront of vaccination efforts, and hence much better equipped to move into the endemic part of the pandemic. Some markets benefitted through their commodity exports from strong global demand, mostly those in Latin America, but also South Africa.
Most importantly though, EMs were in much better financial shape to withstand high USD rates. Structurally, many EM countries have improved their foreign exchange (FX) reserves and macro prudential management – for example countries that can afford it, now issue government debt in local currency, so FX fluctuations are not a threat to debt sustainability.
Looking forward, some EM economies may have the option to ease monetary policy as global inflation declines, which would be supportive of their debt markets. Equally, a China rebound tends to feed positively into EMs, especially commodity exporters and Asian countries. The elephant in the room remains a potential US recession, which could result in higher risk aversion and global USD shortage. Most EM economies, especially those dependent on external financing, will therefore be cautious in their policy setting. But once the current Fed tightening cycle has fed through and global markets are ready to anticipate the next cycle, EM may be another beneficiary.
Outlook for asset classes
Bonds: Bond markets should be much quieter in 2023 than in 2022, but this does not mean yields will fall immediately. On the contrary, we expect central banks – particularly the Fed – to keep monetary policy tight even while headline inflation figures fall. Initially, this may push up real (inflation-adjusted) government bond yields, and put downward pressure on prices (their inverse). But this should not lead to the same bond market disruption we saw over the last year. Markets have adjusted to a very different backdrop in monetary policy, and overall yields will remain more stable. If they rise initially, they are likely to fall later, which is a stabilising dynamic.
Corporate credit spreads have recovered well from stress earlier in 2022 and are no longer signalling defaults across major developed markets. Corporate bond prices have also been supported by tight supply, as companies have put off refinancing long-term debt. The reason for this is because credit costs are too high – deterring companies from issuing more debt. But companies will have to refinance at some point, and the recent fall back in yields will likely tempt many back. That means it is hard to see corporate credit spreads falling much from here. And indeed, if and when we get pockets of bond market volatility, credit spreads will likely widen again – at least temporarily.
The Fed’s concern with a tight labour market means it will probably maintain interest rates despite falling inflation – pushing real rates up rather than down. That could lead to disappointment among bond investors, which could well translate into episodes of volatility. That volatility will likely extend to corporate bond markets. During those episodes, 2023 bond markets will feel a lot like 2022. But the underlying dynamics are different: bond buyers are not on strike following a rapid adjustment to neutral rates, but rather digesting the economic data as it comes through. We should expect tamer markets, but certainly not smooth sailing.
Equities: We expect global equities to be a tale of two halves, especially in the US. The heavily anticipated global recession – if it comes – will mean stagnant or falling corporate earnings, lowering the base attractiveness of stocks. Some earnings negativity is already priced into current equity values, after global stock markets saw heavy losses in 2022. Investors are tempted to look forward to the cycle after this one – when central banks will loosen policy and growth can start again. Optimists are hopeful about the next cycle, pessimists are still worried about this one, and everyone else is caught in the middle. Markets will likely go back and forth between these two modes until the underlying economic data makes it clear who is right.
We expect central banks – the Fed in particular – to keep monetary policy tight despite headline inflation numbers falling back in 2023. That will mean higher short-term real yields and, if that raises longer-term real yields, it may make equities less attractive by comparison. But valuations have already taken a hit, and bond markets have had to adjust. We should therefore expect the ‘normal’ negative correlation between stock and bond values to resume. This also implies investors’ earnings growth expectations are likely to be the defining variable.
Of course, some underlying economies may avoid recession altogether – a scenario which is not implausible in the US – but volumes could be kept positive because corporates are less able to maintain margins, in which case earnings could still take a hit. If the US economy and earnings prove completely immune to 2022’s tightening, then monetary policy would have no reason to loosen, money would stay tight, and risk appetite would have to fall. This is the limbo we are in now, and it will have to end sooner or later. Perversely, just slightly ‘bad’ economic data early next year might lead to rallying stock markets, as it points to a soft landing. And ‘good’ data might similarly lead to falls, as it points to further Fed tightening. We expect markets to bounce between these poles in 2023 until the negative effects of past policy tightening become obvious. The biggest danger though, is that the limbo continues and we end up having the exact same conversation next year.
Property: The backdrop for both commercial and residential property looks more stable for 2023, and certain parts of the sector may even see some upside. Still, next year could continue to be challenging for the property sector, which is facing several headwinds. Overall, we expect commercial property net asset value repricing (to the downside) will gather pace in 2023, as transactions become more frequent, although that will merely make visible what the market already expects.
This year was especially tough for office commercial property in particular – with interest rates rising sharply and demand for office space still below pre-pandemic levels. The key question – across the entire developed world – is whether old work patterns will ever return, or whether there has been a structural shift lower in demand. Residential property prices are somewhat better supported. A lack of savings among younger working age groups has meant they cannot afford to buy but a stable jobs market has meant that they are renting. Thus, rents have increased and the strong price action this year means that rental yields are quickly approaching attractive levels. Meanwhile, slowing economic activity (particularly in the UK and Europe) has meant that very little housing supply has been built. That supply demand imbalance should be supportive of prices. The longer-term problem remains that buyers and renters are being squeezed. Affordability is stretched across major economies and the good rental situation is vulnerable if unemployment rises.
Commodities: We expect the recent pullback in commodity prices will give way to a stable outlook for 2023. Overall global demand should be mildly positive as supply-side problems fade. Moreover, prices will likely be underpinned by a growth boost from China. The backlog created by China’s halt in residential construction will tend to support metals like copper and iron. Equally, a resumption of more normal consumption patterns could help auto-related metals. The longer-term climate-change dynamic will underpin construction-led demand, but a return to the pre-pandemic levels of build may have to wait until 2024.
Energy prices (particularly natural gas and electricity in Europe) have a very high starting point and that typically leads to concerted attempts to improve energy efficiency. Oil prices have now come back down to roughly where they were before the war began – but that itself was already a very elevated price. Meanwhile, natural gas prices are still extremely elevated, despite a fall back in recent months. From that alone it is difficult to see how prices could move significantly higher – particularly in the face of slowing global demand. It seems that Russia’s displacement from oil and gas markets has largely filtered through, and other suppliers have adjusted. Indeed, the latest production decision from OPEC+ to limit supplies further is a recognition of how weak global energy demand is, rather than a show of strength or solidarity.
For much of 2022, analysts talked of low inventory levels across both metals and energy, especially natural gas. Over the course of the year though, for many commodities the global economy had weakened to the point of balance rather than undersupply. Continued global monetary policy tightness – and the consequent fragile nature of global growth – could still see commodity prices being sensitive to lower demand, although metal prices may prove stickier than oil, as climate change infrastructure, construction and car production increases.