Find the silver lining
With a grim economic outlook marred by recession, optimism is low as the new year draws near. persistent inflation.
Inflation is high interest rates continue to climbGeopolitical tensions such as the exacerbated slump in growth expectations and geopolitical tensions such as the war in Ukraine and past fiscal policy errors like the UK’s mini-budget Continue to influence financial markets.
As the world economy slows, investors will need to be cautious and search for silver linings in 2023.
A recession foretold
A painful squeeze is already under way for companies and households as the UK’s independent Office for Budget Responsibility (OBR) offered a bleak outlook, projecting a 1.4% gross domestic product (GDP) contraction in 2023.
According to OECD projections, Russia would experience a stronger economic contraction in 2023 than the UK. This was among the G-20 countries with the most developed and developing economies.
Between the fourth quarter 2019 and the third of 2022, the UK’s GDP fell by 0.4%
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The Bank of England warned the UK that it is currently in the longest recession since records began. The economic downturn is expected to continue well into 2024.
According to consultancy EY, companies have felt it in the balance sheets. London-listed firms issued a total of 85 profit warnings. This is more than any quarter since 2008.
The increase in warnings by consumer-facing businesses was the main reason for the rise in warnings. This number grew almost threefold over the previous year. The report found that 57% of warnings received in the third quarter related to rising costs and 23% were caused by labour market problems.
Over 40% of FTSEs (^FTSE) retailers and over 60% of the FTSE Personal Care, Drug and Grocery Stores sector issued a profit warning in the last 12 months.
“Central bankers won’t ride to the rescue when growth slows in this new regime, contrary to what investors have come to expect. They are deliberately causing recessions by overtightening policy to try to rein in inflation,” BlackRock said.
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According to the markets, this makes recession probable.
“We now anticipate that the UK, the eurozone and China will enter recession in Q4 2022. China is expected to be in growth recession. These economies should bottom out by mid-2023 and begin a weak, tentative recovery – a scenario that rests on the crucial assumption that the United States manages to avoid a recession,” analysts at Credit Suisse said.
Stocks are what we can trust
Stock prices are negatively affected by higher interest rates. Companies are discouraged from borrowing capital and investing to expand their businesses by increasing the cost of capital.
The growth of earnings stocks tends to stagnate. There’s also a negative impact on discounted cash flow valuations, which can hurt high-growth stocks.
Stocks will be a better investment if investors are compensated for any extra risk.
“At a time when calamitous events are in the headlines on an all-too-regular basis, investors will enter 2023 with many questions about the strength and purpose of the political and financial institutions that support global markets,” Iqbal Khan, president of UBS Global Wealth Management, said.
The global wealth manager said 2023 will be a year of inflections and is favouring defensive sectors, income opportunities, “safe havens” and alternatives as themes investors should pursue.
Sectors such as healthcare and consumer staples are considered to be more defensive than those with lower growth expectations. However, value stocks perform well in an environment of high inflation.
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UBS GWM indicated that more attractive opportunities for buying cyclicals or growth stocks could emerge later in 2018, as markets anticipate lower inflation and higher economic growth.
In the first 10 months 2022, value stocks outperformed growth stock by 18 percentage points. This trend is expected to continue next year.
As a result, oil and natural gases prices have risen in the wake of the Ukraine conflict.
Investors have the option of looking to the US dollar or the Swiss Franc for shelter. “Relatively high US rates and slowing global growth should help keep the dollar strong in the coming months, and the Swiss franc’s safe-haven appeal is likely to attract inflows,” UBS GWM (UBS) said.
Amid an uncertain backdrop, seeking more predictable returns from income strategies should also be on investors’ radar, with UBS GWM focusing on higher-quality credit issuers.
Rethinking bonds
Goldman Sachs reports that central banks are increasing interest rates to limit inflation. High-grade bonds are giving stocks a run for the money.GS).
Bonds — the biggest losers of 2022 — could be the biggest winners in 2023.
Credit Suisse is interested in emerging market hard currency sovereigns, US government bonds, investment-grade corporate bonds and other yield curve steepening strategies as bond yields return to higher levels. This causes inflation to peak and central banks to stop rate increases.CS).
“Higher yields are a gift to investors who have long been starved for income. And investors don’t have to go far up the risk spectrum to receive it. Short-term government bonds, and mortgage securities are our favorites. We favour high-grade credit as we see it compensating for recession risks,” BlackRock (BLK) said.
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“On the other hand, we think long-term government bonds won’t play their traditional role as portfolio diversifiers due to persistent inflation. And we see investors demanding higher compensation for holding them as central banks tighten monetary policy at a time of record debt levels,” BlackRock added, warning that there is a new regime playing out meaning that “what worked in the past, won’t work now.”
BlackRock’s new playbook argues that navigating markets in 2023 will require more frequent portfolio changes.
“The case for investment-grade credit has brightened, in our view, and we raise our overweight tactically and strategically. It can be held up in a recession with companies having strengthened their balance sheets through refinancing at lower yields.
“Agency mortgage-backed securities — a new tactical overweight — can also play a diversified income role. Short-term government debt also looks attractive at current yields, and we now break out this category into a separate tactical view,” it said. It’s avoiding long-dated bonds at the moment.
Diversification can be achieved by being overweight in high-rated bonds. However, bond yields already reflect a lot of tightening.
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Goldman Sachs stated that US corporate bonds of investment quality yield nearly 6% and have low refinance risk. They are also relatively immune to economic downturns.
Vanguard stated that while rising interest rates may have caused investors near-term pain, higher starting rates have increased our return expectations for US and international bonds more than twice.
“We now expect US bonds to return 4.1%–5.1% per year over the next decade, compared with the 1.4%–2.4% annual returns we forecast a year ago. For international bonds, we expect returns of 4%–5% per year over the next decade, compared with our year-ago forecast of 1.3%–2.3% per year.”
Investors have the opportunity to lock in attractive real yields (inflation adjusted) with Treasury inflation protected securities (TIPS), close to 1.5% for 10-year and 30-year terms.
“Overall, 2023 will be a good year for income investing,” Andrew Sheets, chief cross-asset strategist for Morgan Stanley Research (MS), said.
Emerging opportunities in emerging market
While US equity continues to outperform international peers, the main driver of this outperformance has been shifting from earnings to currency in the past year.
“The 30% drop in emerging markets in the last 12 months has made valuations more attractive in these regions. Vanguard stated that they now expect comparable returns to non-US developed market markets and consider emerging markets an important diversifier for equity portfolios.
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HSBC is also interested in emerging markets (EM). According to HSBC’s investment arm, “Emerging markets economies are much more resilient against global challenges and EM corporate foundations are at their strongest level for over 10 years.”
EM corporate bonds have an average yield of 8.7%, and an investment grade rating BBB.
HSBC prefers Brazil and Mexico over the GCC because they have shown “more economic resilience” to the current global environment.
When will the central banks reduce rates?
Investment banks are convinced that the decisive monetary policies have caused inflation to peak in many countries. However, central banks are signalling they will raise rates further to address a hot labour market and reduce demand.
“We believe central banks will eventually reverse their rate increases as economic harm becomes a reality. BlackRock indicated that they expect inflation to fall but remain above central bank targets of 2.2%.
Markets in the US are pricing in a less dovish Federal Reserve. This indicates that there is a possibility that the US central banking will start to lower its funds rate before the end of next fiscal year. Some believe that there won’t be any rate reductions in 2023.
Credit Suisse stated, “Although the pace at which tightening is expected to peak by 2022 end, we don’t expect any central banks from developed markets to reduce interest rates for 2023,” Credit Suisse.
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For JP Morgan Asset Management (JPMAssuming that headline inflation is decreasing and wage inflation is falling, it expects US interest rates to rise to approximately 4.5%-5.0% by the first quarter 2023 before reversing course. Similar to the US, the ECB will likely halt at 2.5%-3.0% for the first quarter.
“The Bank of England Due to the fact that inflation is more likely in the UK, it may take a little longer to reach its peak. It said that the peak UK interest rate is expected to be 4.0%-4.5% by the end of the second quarter.”
Reducing inflation
Inflation hitting multidecade highs could cause investors to be whipped in 2023. As German economist Karl Otto Pohl put it, inflation is like toothpaste; once it’s out, you can hardly get it back in again.
“The fear is that monetary policies alone will not be able to control this self-sustaining inflationary climate. Christine Lagarde of the European Central Bank admits the world won’t return to the pre-pandemic low-inflation environment,” Neil Wilson, chief analyst at Finalto, stated.
“Markets are obsessed with the idea of a pause, or a pivot, and when it might occur. This is the wrong way to view it. Christopher Waller, FED governor, said that it was time to pay less attention to how fast things are going and instead focus on where the endpoint will be. The endpoint of inflation will still be a long way off until we can bring down inflation.
Despite the grim outlook for investors, there are still ways to beat prices.
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“I believe 2023 will prove difficult for businesses and households.” However, my main argument is that it could work better for investors,” Tom Stevenson of Fidelity International stated.
Morgan Stanley favors European value plays, where banks and the energy sector offer higher than average dividend yields.
It said: “We think that this is an exceptional environment for generating high single-digit returns from high-quality assets, an opportunity that hasn’t presented itself for a long time.”
The outlook for 2023 by the investment bank highlights opportunities to invest in Japan and early cycle emerging markets for between 11-12% returns.
According to Mike Wilson, chief investment officer at Morgan Stanley and chief US equity strategist, investors need to be more strategic and pay closer attention to the economy and corporate earnings.
“Because we are closer to the end of the cycle at this point,” Wilson said. “Trends for these key variables can zig and zag before the final path is clear. While flexibility is always important to successful investing, it’s critical now.”