Investment Strategy Observations January 2023

Ronan Smith

1. Review of Markets in 2022

2022 was a tough year in which most markets did very badly from the perspective of most investors. There were various coincident factors behind this, including;

  • War
  • Inflation
  • COVID in China leading to an economic slowdown
  • Continued production and trade interruptions.

But the biggest impact on capital values was the consensus that recession was coming while central banks ignored that and reacted sharply to the strength of inflationary surges, ending the era of financial repression.

The emperor’s clothes were seen for what they were in the IT sector. Tech stocks lost heavily and the vulnerability of these leading companies, individually, was highlighted by Elon Musk’s adventures with Twitter.

Bonds had a record year of losses, as had long been expected.

Economic activity continued to recover globally in 2022, according to the World Bank, but at 2.9%, much slower than in 2021. They forecast 1.7% growth this year before increasing again somewhat in 2024. They do not anticipate negative growth for the year in any major country or region except Russia. Many analysts would regard the 2023 forecast as optimistic.

China, despite a marked slowdown in growth, is still increasing its share of global output, which should reach 19% next year. India’s economy is now bigger than the UK’s, ranking fourth in the world and due to grow faster than any of the top six.

Both equity and bond markets exhibited increased volatility.

From the perspective of a domestic investor in each main country, equity returns were as follows:

US and Chinese equity markets were impacted by the flight from growth stocks, largely tech companies. The UK was a winner largely due to the composition of its market. India demonstrates that there were winners and losers in the developing world too.

To explore such comparisons, here are the returns in common currency:

Returns in the Eurozone were nearly as bad as those in the US, but here the reasons had more to do with the effects of the war, energy problems and a bleaker economic outlook. Japanese returns were badly affected by the weak Yen. UK equities also did very well in currency adjusted terms, relative to others. As mentioned above, this was structural: energy accounts for 13% of the UK market, but only 5% of the Developed World and clearly had a very good year. Financials also did well, many benefiting from higher interest rates, and the UK is also significantly overweight in these stocks. But tech stocks, which account for 20% of the Developed World, have only a 1% weight in the UK. These were the worst-performing stocks.

While equity returns were very bad for Irish investors, they would have been much worse had the euro not been weak. This could easily reverse (and it already has to some extent over the past six weeks). Continued currency volatility presents an additional risk to internationally diversified portfolios.

The choice between developed or emerging markets made little difference. However, both DM and EM aggregates concealed huge variations among countries. India emerged almost unscathed. Indonesia gained 12% in euro terms. Brazil, Chile, Mexico, Singapore, Thailand, Greece and Turkey all posted significantly positive euro gains.

Equities may have been unusually weak, but bond markets broke records for losses. Euro interest rates rose faster than ever before, driving yields much higher. Over-ten-year eurozone government bonds lost 32.2%. Even short-dated bonds lost 7.2%.

Has all this loss-making resulted in more affordable markets?

Equity yields would suggest the answer is ‘yes’: The (historical) dividend yield on global equities increased by 40% – 50% over the course of 2022. Price-earnings ratios (also historical) tell an even more dramatic story, falling from 32.1 to 14.9 during 2022 in developed markets. Emerging market P/Es fell from 18.7 to 11.6. (Data from FTSE).

The following JP Morgan chart uses forward P/Es (for MSCI World) and shows that they are now just below their average over the past 33 years.

Source: J.P. Morgan Asset Management

Based on cyclically adjusted earnings (CAPE), US equities are still looking historically expensive despite better valuation. The theoretically expected return over the next ten years based on this CAPE model now stands at a little over 2% in excess of the risk-free rate.

Source: Robert J. Schiller

Equities are significantly cheaper than before but are not pricing in a recession or the likely significant contraction of earnings. The imbalances in valuation between the tech giants and the rest still exist but are much less marked than they were last year.

Bonds now offer attractive current yields for many investors. Euro government yields at end 2022 were 3.48%. AAA bonds were at 2.6%. Corporate investment grade bonds yielded 4.36%. If markets have anticipated monetary policy correctly, bonds should offer decent returns this year. However, should central banks find it necessary to keep elevating rates to tame inflation, bond yields will have another few steps to climb and returns could be poor again, though nothing like as bad as 2022.

Either way, the bond market environment has changed radically. The era of excessive fixed-income valuation that has prevailed for most of the past decade is now over, and investors are adjusting their allocations to the asset class accordingly. This means that, even if further reversals in bond prices occur, they should be tempered by a wall of available institutional buyers.

2. Inflation Outlook

The outlook for markets pivots on the outlook for inflation.

The roots of inflation reach all the way back to the Great Financial Crisis and the loose monetary policies that ensued. This created the conditions for inflation to occur, without which there could not be any general rise in the level of prices. Economics, however, does not possess a modelling tool that can predict when inflation will actually materialise. For years, loose monetary policy pumped asset prices but did not affect consumer prices. It was only when the shortages of 2021 began to bite due to trade and output bottlenecks as economic activity resumed rapidly after COVID lockdowns, that prices began to take off.

Bottlenecks are now working their way out of the system. See the left side of the JP Morgan chart below. Analysts and policymakers alike are confident that inflation has peaked because the proximate cause of the inflationary surge is likely to disappear. However, that does not signify a resumption of steadily low rates of inflation close to central bank long term policy targets (around 2%). There are three great unknowns that will determine the future course of inflation:

A) Has inflation already become embedded?

Labour markets are tight. The right-hand chart below shows the proportion of unemployed persons for whom there is a vacancy (not necessarily a suitable one). Since COVID, labour markets have tightened, especially in the US and UK. Wages have grown significantly in the US, by 7% last year, and unemployment is back to pre-COVID levels. The UK economy is riven by strikes, the main thrust of which is to seek compensation for the inflation that has already happened there.

Again, economics has no answers. Nobody knows what level of interest rates will supress activity sufficiently to weaken wage pressures without causing a significant recession, high unemployment, and widespread corporate defaults. History suggests we should not expect central banks to be lucky enough to find a ‘sweet spot’.

US inflation is about 7% now, of which close to 3% may be attributable to bottlenecks that should unwind. If inflationary expectations are not embedded and no further sources of inflation arise (both are big ‘ifs’), that could result in inflation dropping to about 4%, but not to 2%.

Source: J.P. Morgan Asset Management

B) Energy and materials

The most significant bottleneck, in Europe at least, has been natural gas. Oil also suffered market shortages. These do not feature prominently in the outlook of many analysts for 2023. However, the reason that energy prices have fallen sharply over the past 6 months or so is because the northern hemisphere managed to secure enough stored energy to last through this winter. This was only possible because the weather in late 2022 was warmer than average. Stocks, however, will be used up by March and the process of restocking will begin again. Cold weather and blocking tactics by Russia are two possible risks that, should either occur, could see a resumption of shortages and price spikes in energy.

There are also shortages and rigidities in the supply of many of the metals necessary for the electrification of vehicle fleets, a critical element in the plan for environmentally sympathetic global growth over the next 20 years. For many reasons, we are sure to see much change in how resources will be found, produced, traded and delivered. Such change will be a longer-term source of continuing interruptions in supply, and of further inflation.

Markets for industrial commodities and energy are all about China. That country is a dominant user of all such inputs and a dominant or even monopoly supplier of some. China’s pattern of demand and output was distorted by lockdowns and recently by re-opening. Capital Economics has concluded that re-opening will generate a short-term inflationary impact in China that should fade later this year and that the impact on global prices will be insignificant. However, within their analysis, the pattern of changing Chinese demand and supply, while weakening commodity prices in the short term, could result in longer term upward pressure, especially on oil.

C) Monetary Policy

During 2021, the Fed (and other monetary authorities) said inflation would be transitory and modest. Inflation reached 5% at mid-year and held. When it broke out in late 2021, I thought the Fed might be afraid to tackle it head on, but they were not. Policy rates rose from 0.25% to 4.5% during the year. The Fed promises more tightening (5.25%) before they ease off later this year. The market forecasts that the Fed won’t reach that peak and will ease off earlier. I find this odd.

What can the Fed say? If they believe, as I do, that inflationary pressures will persist under current conditions, and that further rate increases will be necessary, saying so would only inflame inflation expectations, thereby embedding a higher level of inflation in the system. They are forced to speak as though their policy will be successful. If they try to pre-empt inflationary pressures by raising rates further significantly and quickly, they risk severe reaction in the real economy, resulting in a recession. So, they announce that they are still on an upward but slowing trajectory. If they believed that inflation has been defeated, they would say so.

I also believe higher rates are required to choke inflation because large cash balances are available for spending. Consumer and business balance sheets are in reasonable shape – significant cash balances have been accumulated during quantitative easing. Inflation can cause the holders of such ‘idle’ balances to start spending the money before it loses value. Whether the spending impetus becomes material depends on whether inflation expectations become embedded in deposit-holder’s thinking. Central banks may try to convince them otherwise but that is a tall order.

Most economists forecast a quick decline in inflation in the US to between 2% and 3% by the end of 2023. For all the above reasons, I do not see that happening. Yes, inflation has peaked, but to stop it resurfacing, interest rates must be high enough to do real damage to the labour market. I have been surprised by the speed at which the Fed have raised rates but they still need to go further. Inflation will probably remain about 5% until a recession, even a mild one, reduces labour market pressures.

Source: J.P. Morgan Asset Management

Longer-term forces suggest that inflation will be a continuing feature, the main reason being the absence of a continuing global supply of cheap labour. The following chart from BCA shows the global ratio of workers to consumers. Dependency is inflationary, so, I expect inflation to clock in frequently at about 5% for some years, though it will dip during any forthcoming recession.

Source: BCA Research 2022

These conclusions are similar for the Eurozone and the UK, though the UK’s economic outlook is particularly troubled. The level of inflation and necessary interest rates in the Eurozone are slightly lower than in the US to date but the structural energy problems here could push normal inflation rates up towards the US level.

3. China

China’s economy is still 20% smaller than the US, but it holds all the aces to win the next geopolitical and economic struggles of the superpowers.

The Chinese Belt and Road Initiative involves cooperation agreements with about 140 countries, including 21 European countries, covering infrastructure projects, access to mined resources, trade routes, and education. 60% of the global population is covered by the initiative (see map). As well as key trade routes, the policy includes leading the exploitation of the Ice Corridor along Northern Russia which will soon be accessible for year-round trading, due to global warming. China has wrapped up access to Africa’s metals (where US companies have none) and have dominant worldwide shares of the vital materials for the manufacture of batteries, so they should benefit most from the electric vehicle revolution.

They also have substantial resources in orbit to win control of military resources on the ground. This may break out as a major diplomatic issue, perhaps in conjunction with the invasion of Taiwan, in the next few years.

Source: Owensson, Wikipedia

An invasion of Taiwan appears more and more inevitable in the next few years and could pose a threat to western economies. The necessary military response could explode budgets that are already quite stretched, while sanctions would stitch up payments that are necessary for western trade because of China’s ubiquity in the global real economy. From a Chinese perspective, the time for a gradual encroachment on Taiwan is fast approaching.

All of this signifies for me that the Chinese economy is worth investing in, taking a 5–10-year view, as long title to assets there will be protected. I believe China will remain respectful of international title to investments by foreigners as it is fundamental to China’s ambitions, which are long-term and supremacist, that the country would play a constructive role in international trade and capital markets.

4. A selection of views

There is much agreement among most commentators I have read and met regarding the current positioning of markets although there are subtle differences that could have significant implications for investment policies.

On monetary policy for this year, most see the US as leading Europe and the UK while Japan remains somewhat detached. In the US, they see short rates rising further, taming inflation quite quickly to a level where there is a positive real interest rate, and then rates being cut to avoid or reduce the severity of a recession. For markets, this is the optimistic view, particularly for bond markets.

Others are, I believe, somewhat more realistic about the choices facing the Fed. They also see a sudden reversal of inflation, but think a recession is inevitable. Most suggest that it should be a moderate or shallow recession. All seem to agree that, while the equity market is more rationally valued now than a year ago, it does not discount a recession.

While some leading houses disagree about how far rates will rise and then how far they will fall, there is agreement among some thought-leading houses that when rates do fall, the terminal rate will be about 3% or, for some, higher as long-term inflationary factors will justify a higher policy inflation target than heretofore, at 3%.

Many argue that US inflation will continue to slow, but not quickly enough to avoid a recession. And some argue that inflation is unlikely to come under control, as the labour market is so tight, unless rates rise higher and for longer than the market expects.

All agree that economic conditions in Europe are more difficult in 2023, because of energy issues and the war, and that recession is virtually certain here. However, Europe may well grow faster after that. A key variable will be the strength of import demand from China.

Most agree that while European Equities may be somewhat negatively impacted by short term economic factors, they are protected by a massive valuation cushion. While it might take some months to play out, European (ex UK) Equities are likely to outperform US Equities.

The outlook for developed market economies is modest but most regard the equities in these countries to be reasonably cheap. China was not, until recently, expected to resume its high growth rate in the next year or so. However, analysts considering the re-opening of the economy following the sudden reversal of lockdown policies suggest it will bring the growth agenda forward into this year.

The implications for currency, while always very uncertain, have found a degree of consensus too. Most suggest that the USD has benefited from stronger growth than other regions, from uncertainty driven by global inflation and war, and from the Fed acting ahead of other central banks in raising rates. As other central banks catch up, and as inflation eases, they expect the euro to strengthen against the USD. Some of this has, in fact, already happened.

5. Investment Outlook

The two big secular changes in the investment environment derive from the change of global monetary policy. The first is that bond yields are now at a potentially sustainable level so investors can revert to a neutral weighting in Government Bonds. The second is that the ‘Central Bank Put’ is dead. So, when markets next become nervous across the board, support will not come from the authorities either for equities or bonds. Therefore, risk has increased.

My forecast that inflation is not licked, and that it will be sustained at an elevated if not dramatic rate for some years, suggests that Government Bond yields will rise further. The market should whiplash a few times as natural bond holders buy dips in bond prices and as forecasters conclude that recession is more likely and possibly more severe with each escalation in interest rates.

That is just a one-year highly uncertain forecast. The more important point for portfolio construction is that bonds offer some value and may be a necessary counterweight if equity outcomes are disappointing again.

Earnings forecasts are significantly down and many analysts see them coming down further – they do not account for recession. Equity values are not stretched in aggregate but are vulnerable to two alternative scenarios: Higher interest rates that do, in fact, cause a material recession on the one hand; and much lower inflation, which would be bad for earnings, on balance.

The main reason why 2023 will not be as bad as 2022, is that last year’s occurrence of simultaneous losses in both equities and bonds was highly unusual. Whatever happens, they will probably not both lose significantly next year.

Longer term, subject to the risks that exist at all times such as the effect of wars, pandemics, massive failure of regulation and so on, equities should manage to eke out real returns in excess of those on other asset classes, but the excess is likely to be smaller than we have been used to.

16 January 2023

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