Chris Iggo
There are four themes which I think investors can get their teeth into this year.
The first is disinflation which will reduce the need for additional increases in interest rates beyond what is already priced in i.e., 5% for the US Federal Reserve’s fed funds rate; 3.25% to 3.5% for the European Central Bank’s deposit rate; and 4.5% for the Bank of England’s bank rate. The second is the scope for some reversal in the increase in real bond yields that occurred last year. Lower real yields would be positive for bond returns but also for how equity earnings are discounted, boosting the prospects for quality growth equities. The third is the re-opening of China which has already led the consensus view to be underweight US equities and overweight China (and Europe as a beneficiary of increased Chinese demand). The fourth is the potential for increase infrastructure spending in the US.
Inflation coming down
The economics profession did not prove to be very good at forecasting inflation in 2021 beyond that it might go up. As such, any speculation that it will come down again carries the usual health warnings. However, disinflation is underway. In the US, both headline and core consumer price inflation peaked (in terms of year-on-year changes) in June and September respectively. Producer price inflation peaked even earlier, in March of last year. In the Eurozone, the peak looks to have come later, in October for the headline consumer price rate with the core rate still rising as of December 2022. Consensus forecasts for inflation for most major economies and a range of emerging markets for 2023 are for declines relative to 2022’s average inflation rates.
Further declines in inflation rates in the months ahead should be a positive driver of returns in both bonds and equities. The implications for interest rates are clear, which should boost bond performance. For equities, more price stability should allow greater clarity on costs and profits which should in turn allow more confidence in earnings forecasts. Regimes where the year-on-year rate of inflation has been falling are associated with the strongest equity returns in recent decades. The nirvana, which is probably beyond reach for now, is a return of inflation to the pre-COVID-19 norm of close to 2%.
Q1 is a risk to the disinflation view
The early months of 2023 will be telling. The first half of the year tends to see the highest monthly increases in prices as wages and prices are increased. Given the amount of industrial action currently plaguing Europe there are some upside risks. Similarly, the re-opening of China might contribute to higher global energy and commodity prices, re-invigorating upstream costs for global companies. Yet the trend towards lower inflation should dominate and that is what will be important for market performance.
Lower for growth
US real yields have not moved down enough yet to reverse the outperformance of value versus growth but – at least in the first part of January – growth has started to come back.
China open
China’s re-opening is both an equity and bond story. Both global and local Asian investors are likely to increase their exposure to Chinese equities, providing further support for the rally. On the fixed income side, Asian credit has already benefitted from more optimism around the Chinese growth outlook and the property sector’s stabilisation. With investment grade Asian US dollar-denominated bonds yielding in the 5%-to-6% range global credit and emerging market bond investors are also likely to up their allocation to the region.
Green
The fourth big theme is the potential for an acceleration of investment spending in the energy transition. In the US this is linked to the Joe Biden administration’s Inflation Reduction Act which will provide subsidies up to $465bn for investment in renewable energy, electronic vehicles, semi-conductors and other technologies. It also specifies that a lot of the content must be US produced. The politics of the Act are seen as protectionist and anti-globalisation but the spending it could unleash is likely to be a significant multi-year theme for US businesses. In the rest of the world, governments are also likely to play a similarly interventionist role to address the need to meet CO2 emission targets and respond to heightened concerns about security in energy and technology. Global supply chains in many of these areas are sufficiently complex to suggest that companies operating in several markets will benefit, despite the temptation to favour local producers. It’s interesting that over the last three months, the sectors leading the recovery in the S&P 500 have been industrials and materials.
Stocks with upside in the next phase of the cycle
Tight labour markets in the post-pandemic world and generally more expensive labour, together with constant innovation in areas like artificial intelligence, should boost the long-term outlook for parts of the technology sector. I would expect companies which can demonstrate steady earnings growth this year, in a world where sales growth is harder to come by, will be rewarded by higher stock prices. Companies in the consumer staples, healthcare, and IT sectors, globally, likely offer the best prospect of stable long-term earnings growth – and currently their earnings forecasts, at a global level, have proved to be the most resilient.
Central banks ahead
In the short-term the market rally is likely to consolidate, and we could see some weakness in the next couple of weeks with Chinese New Year and key central bank meetings coming up. Central bank officials have engaged in the usual pre-meeting warnings about the need to keep increasing interest rates. Of course, they do so because they have not reached the levels the market has been expecting them to get to. Relative to market expectations, the Fed needs to raise rates another 50 basis points (bp), the ECB another 125 to 150bp and the Bank of England another 75 to 100bp. I am not sure the ritual hawkishness is anything new in that regard. The next battle of wills between the market and the central banks will be over the extent to which rates stay at their peak and what the next move will be after enough time is spent there. The consensus is that slower growth and lower inflation means there will be cuts in rates to look forward to. That is not for now though. First, we need to see disinflation, the reversal of real yields and investors responding to some of the key medium-term growth themes which are starting to emerge.
By Chris Iggo, Chief Investment Officer, Core Investments