Pause and assess
- Any indication of a pause in hikes, especially from the Fed, should boost markets further
- Sentiment is extremely negative, which could support the upward move
- Softness in labor and inflation data would be key for investor sentiment
As we get ready to close the books on 2022, one of the worst years ever for the 60/40 portfolio, investors are hoping that the worst is behind us, though, importantly, most do not believe it is.
The last few data points of the year should highlight that inflation is coming down and that disinflation is set to continue into 2023. Indeed, hard CPI data appears to finally be aligning with soft indicators pointing to disinflation. This should support markets into the end of the year and into the beginning of next year.
However, a number of risks remain on the horizon, which could start to creep in during the second part of Q1 2023.
The biggest question for investors remains that of inflation and Federal Reserve policy. Throughout 2022, every time the markets hoped for an imminent end to the aggressive tightening path, the Fed announced a higher terminal rate, and markets took another leg lower.
Today, we believe that we are finally nearing the end of this tightening cycle. A 50bp hike is expected in December, with the possibility of another 25bp hike in January. Beyond that, we believe that data will show enough indications that inflation is declining. The labor market is also starting to show signs of softness, though a lack of employees in a number of industries suggests it will not crack. Finally, the housing market is deflating as well. It will take time to reflect in the hard inflation markers, but the trend is downwards.
Encouragingly, growth and consumption are holding up better than anticipated. Many already expected a 2022 recession, which did not materialize. For 2023, the jury is still out, but if the Fed does lift its foot of the tightening pedal, an elusive soft landing is still a possibility. The savings cushion provided by the massive Covid fiscal packages is still helping consumers, which should allow for some resilience in growth.
Improving growth prospects?
In Europe, the picture is a little different. The Ukraine War is bringing about an energy crisis that is set to weigh on growth. Even though gas storage levels are full, we are still at the beginning of winter, and once gas is used, we’ll have to think of how to refill them. Still, with the reopening effect still supporting growth and unemployment very low, growth is holding up better than expected, but 2023 will probably still be painful. The European Central Bank is therefore in a complicated position, as it knows growth is slowing and recession is likely, but it needs to bring down inflation from the current 10% back closer to its 2% target. Still, a lot of the inflation is due to higher food and energy prices, as wage growth has remained relatively contained, which suggests it could retreat further is energy prices do not spike again.
China is also facing a complicated growth picture, with the bursting of its real estate bubble and the impact of its zero-Covid policies.
Perspectives for 2023 are slowly improving though, as the government is gradually moving away from its strict Covid measures, though we still think it will take time before we see an end to zero-Covid policy. Additionally, policymakers are increasing support for their beleaguered real estate sector, which should see some improvement over the coming year. Combined, these are leading to optimism about Chinese growth prospects, and should also finally start to boost domestic demand, which has remained subdued since the onset of Covid restrictions.
Sentiment to recover
With central banks likely at peak hawkishness and inflation expected to fall over the coming months, investor sentiment should find some support. This recovery in risk appetite is also likely to be supported by the extreme negative sentiment that remains consensus.
Yields have already come down, a trend which should continue as the Fed closes in on a pause – even if rates stay higher for longer – and growth slows. This has already helped support equity markets, allowing P/Es to rise again. In addition, the dollar is retreating for similar reasons. This should support earnings prospects for 2023, as the strong dollar was a key headwind for corporates this year. Increasing confidence in the possibility of a soft landing, if the Fed eases off rate hikes, should also support earnings expectations, which have already dropped sharply.
A fall in yields should also support the tech sector. Indeed, the massive run up in yields in 2022 put significant pressure on big tech, which contributed to some underperformance for US equity indices. However, we believe that solid earnings and lower yields will help tech recover, leading US performance to surpass that of other regions, which have already benefited from a view that the worst is behind for them, while this has not occurred for the US.
Emerging markets should also benefit from improvements in Chinese growth prospects. Policymakers are moving to support the real estate sector, while also pledging to support growth, which should also occur through a softening in Covid measures. Combined, these should boost sentiment and allow Chinese equities to lead the region higher, though of course, risks remain.
No all clear, but still constructive
While we are more constructive than the consensus for 2023 and believe the year as a whole will be positive, we expect the first half to prove rather volatile, as a number of risks remain on the horizon.
The first big risk is that inflation stalls and does not keep dropping. This could upend any Fed pause expectations and lead markets to reprice for a higher terminal rate and another round of interest rate hikes.
The second risk is that the lagged effects from the aggressive tightening the Fed has done so far finally occur, leading to a sharp slowdown in growth. This would lead to a repricing of growth and earnings and would weigh on markets.
However, both of these are more likely to happen during the first part of the year, suggesting the second half should be more constructive for markets and for risk appetite.
Overall, we position for optimism with some caution as we are not near getting an all-clear for markets, but the clouds should clear throughout the year.