Arif Husain

T. Rowe Price released its outlook for global financial markets in the second half of 2023 which suggests a reluctantly bearish view for the short term, with more room for optimism over the longer term.

The resilience of many world economies is being tested, as the effects of a steep, global interest rate hiking cycle and a shift to quantitative tightening are still being felt. Labor markets remain strong and are an important signal for investors to watch as any softening could increase the risk of a recession.

Although equity markets have delivered gains in the first half of 2023, earnings estimates may still be too high for a weakening economy, putting further pressure on equity valuations. Bonds, which suffered in 2022 alongside stocks, present potentially attractive opportunities in high yield, selective sovereign bonds and local currency debt in certain emerging markets.

Arif Husain, Head of International Fixed Income and Chief Investment Officer said, “I am bearish because the risks are substantial, but I am also reluctant because excessive pessimism can lead investors to overlook opportunities and miss potential market recoveries.”

“I think some financial indicators also could be sending misleading signals about the near‑term direction of central bank policy rates. The market is trying to reconcile two very different scenarios – one where the U.S. economy remains fairly strong and the Fed doesn’t cut rates, and one where the Fed has to cut by several percentage points. The Fed and other central banks in developed markets will lower rates eventually, but the timing is tricky. Rates are likely to remain higher for longer. This could mean an aggressive portfolio shift into longer‑term bonds appears premature. Some emerging markets may be on the verge of rate cuts, but they are only attractive on a very selective basis.”

“Japan, as a last anchor of quantitative easing, could be about to give way. If the Bank of Japan allows yields to rise, Japanese investors who control the world’s largest pool of financial wealth could start bringing their wealth back home, delivering a significant shock to markets outside Japan. This could end up being a lot more important for markets than whether the Fed hikes or cuts rates at its next meeting.”

Sébastien Page, Head of Global Multi-Asset and Chief Investment Officer said “Many economic indicators are flashing red but lingering distortions from the COVID pandemic make it hard to distinguish the signal from the noise. Stock valuations aren’t broadly attractive right now, but opportunities exist in some asset classes. U.S. small-cap stocks, for example, are trading at significant discounts to their historical averages and priced like it’s 2008. However, since smaller companies historically have been more vulnerable in economic downturns, it takes skilled security selection to help avoid those with weak balance sheets and high cyclical earnings exposure.” 

Justin Thomson, Head of International Equity and Chief Investment Officer said:  “The welcome boost to global growth in the first half of 2023 delivered by major eurozone economies and China has mostly faded. On the other hand, Japan’s strong momentum continues, driven by a weak currency that has supported the export sector, a return of pricing power of corporations, and positive governance reforms that have taken root.”

“Potential opportunities may be available among the mega‑cap technology companies that were hard hit in 2022, with artificial intelligence (AI) driving investment in a range of tech sectors such as semiconductors, memory, and cloud storage. An AI arms race means the strong tech companies are likely to get stronger.”

Thomas Poullaouec, Head of Multi-Asset Solutions, APAC and Chair of the Asian Investment Committee said: “The Asian economies are at a different stage of their business cycles compared to the rest of the World. The recovery post COVID is still in its early stage and has not fully played out, with the recovery in regional tourism still underway, for example. Inflation is not as big of a concern as elsewhere, which allows selective Asian central banks to ease policies earlier than in the major developed economies. This tells me that it’s too early to give up on Asia.”

“Finding opportunities in Asia requires a new playbook for a few reasons. First, China’s service-led recovery will unfold differently compared to previous infrastructure-led recoveries. Second, geopolitical tensions are changing supply chain models. Third, economic momentum is decoupling. For the second half of the year, we maintain an overweight position in Asian equities and bonds, leveraging our active research platform to selectively pick the sectors and companies that can best navigate this changing landscape.”

Investment ideas

The spokespeople highlighted three investment ideas for 2H2023:

• Maintain flexibility and keep “dry powder” – Global economies have been resilient but are not yet out of the woods. With short‑term yields at attractive levels and economic uncertainty high, it makes sense to consider maintaining healthy cash balances for now and being ready to use the proceeds when clearer signals on inflation and monetary policies arise.
• Take advantage of attractive yields – Bonds may not be a good source of capital appreciation in 2023 but do provide yield. Equity upside may be limited by an uncertain economic landscape, so high yield bonds and emerging market bonds may offer better return opportunities.
• Equity markets with unique profiles – U.S. small‑caps offer attractive valuations. Asian companies’ earnings are expected to benefit from the ongoing recovery post COVID. Structural changes in corporate policies could be a long‑term tailwind for Japanese equities. Mega‑cap technology companies are well positioned to benefit from artificial intelligence.
  

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• Macroeconomic outlook remains mixed as data has been surprising to the upside, despite evidence of tightening financial conditions that are still expected to weigh on economic growth in the back half of the year.
• Widening gap in monetary policy likely ahead as the Federal Reserve (Fed) is expected to pause, as is the Reserve Bank of Australia, while the European Central Bank and Bank of England remain hawkish. Meanwhile increased uncertainty around Bank of Japan persists under new leadership as they evaluate yield curve control policy.
• Key risks to global markets include a deeper than expected decline in growth, central bank missteps, persistent inflation, and geopolitical tensions.

Market themes

Back In Business

With the Japanese equity market trading near 30-year highs, investors are questioning if it has staying power this time. Japan has been on a long climb back since their “asset bubble” burst in the early 1990’s and were hampered by decades of weak growth and low inflation. However, today does seem different, underpinned by both structural changes and cyclical tailwinds, with inflation finally showing up–a good problem for Japan, unlike others–that can help stimulate consumption through higher wages. Corporate governance reforms, a key part of “Abenomics,” are also starting to show real progress in improving shareholder value through higher buybacks and dividends.

A weaker yen, pent-up demand from reopening, record foreign inflows and still relatively cheap valuations have been strong tailwinds. Despite the optimism surrounding Japan’s comeback, the months ahead will be closely watched as the more cyclically oriented economy navigates slower global growth and the Bank of Japan looks to unwind ultra-easy policy. For now though, Japan looks back in business.

What if?

Our base case remains that the Reserve Bank of Australia (RBA) is getting close to the end of its tightening cycle despite recent market re-pricing.

Wage growth inflation should be contained due to an influx of migration, growing the population by 1% per year at the current rate. Moreover, mortgages are still being reset: the RBA estimates that scheduled loan repayments will increase by end-2024 to levels not seen in the past 20 years. This suggests an economic slowdown and a reason for the RBA to re-consider their recent hawkish tone. What is the likely scenario if our base case doesn’t materialize? We think that the risks are on the upside for the economy which would lead to further rate hikes in the coming months. In fact, house prices appeared to have already bottomed at levels higher than in the pre-COVID period. Perhaps unnoticed, the main beneficiary in terms of higher income has been the lower income earners. So, the upside risk for the Australian economy is that households turn out to be more resilient to digesting higher mortgage payments.

The economy could then re-accelerate from here, leading the RBA to be much more hawkish than current market pricing. We could return to an environment where Australian assets would be again seen as a high carry play, akin to the early part of the 2010s period. This is the “What if” scenario that we believe investors should start to prepare for.

Portfolio postitioning

• While we maintain a cautious stance with an underweight to equities in favor of fixed income, we decided to rebalance our portfolio and used some cash to buy equities. We still think that equities remain vulnerable to a slowing economy and weaker earnings backdrop, while central banks’ bias, albeit moderating, toward inflation fighting remains a potential headwind to bonds. However, we recognize the recent price action in equities and would like to reduce our active risk through re-risking the portfolio.
• Within equities, we reduced our underweight to the U.S. and European stocks as unrealistic expectations have partly been adjusted and investors are seeking secular growth trends, like artificial intelligence (AI), amid weakening economic backdrop. We are also adding to our overweight in Japanese stocks with our conviction growing on the back of an accommodative central bank, modest reflation, and solid corporate governance reform. This was funded at the expense of Emerging Market stocks where our conviction on the China recovery was eroded based on the most recent economic and sentiment data.
• Within fixed income, we added to Australian duration with a view that the future economic slowdown will start to weigh on long term yields. Additionally, we increased our overweight to long-term U.S. Treasuries as a risk hedge and on expectations that rates have peaked in this cycle.

By Thomas Poullaouec, Head of Multi-Asset Solutions APAC

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