Investment Outlook January 2023

The volatility we have seen the past year inside the equity markets exceeded (on a three year rolling basis) what investors had to bear with during the financial crisis of 2008/2009. So it is safe to say, 2022 was a challenging year from a financial point of view.

Equity markets were down in 2022 while interest rate increases led to new peaks in bond yields, bringing their prices down in a way the market hasn’t seen it for decades. The negative correlation between stock and bond prices we have seen in the past broke down spectacularly, and investors had basically no safe heavens over the past 12 months.

So what then is our outlook for 2023? While we are still positive in general on the long time horizon, the above mentioned events undoubtedly darkened the short to mid term outlook somewhat.

It is true that inflation is coming down again, but slower than the central banks of Europe and the United States probably hoped for, so we don’t doubt Jerome Powell when he says “Restoring price stability will likely require maintaining a restrictive policy stance for some time”, meaning we do not expect a dovish turn of the FED or the ECB soon, and expect the interest rates to stay on their respective levels for some time.

In the US, we think the second half of 2023 could see some moderate interest rate cuts, and thus could be a good point to pivot again more aggressively into the markets. In Europe, much depends on the situation with Energy supply, especially after the embargo on Russian oil (we are having a warm winter now, but can we count on it in 2023 again?), and on how investors will see the sovereign debt situation in the south of the Eurozone amidst rising interest rates.

In any case, we think that the burst in inflation will have long lasting effect on the baseline level of future price changes, meaning it is perfectly possible that the central banks adjust their mid term target silently to levels above 2% annual inflation.

BENDURA market views

The terms attractive / unattractive describe the return potential of the various asset classes. An asset class is considered attractive if its expected return is above the local cash rate. It is considered unattractive if the expected return is negative. Very attractive / very unattractive denote the highest conviction views of the BENDURA Investment Committee. The time horizon for these views is 3-6 months.

Year in Review

Together with 2002 (bursting of the dotcom bubble) and 2008 (financial market crisis), the year 2022 is certainly one of the worst in recent capital market history and can certainly be described as an "annus horribilis". It was a year full of difficulties - a multi-crisis year. The beginning of the year, with the encouraging progress made in overcoming the covid pandemic, was very promising and the markets looked to the new year with great confidence. However, the positive mood and the emerging economic recovery were abruptly halted on February 24, 2022, when Russian forces attacked Ukraine. Geopolitics proved to be an important driver of the global economy in 2022.

The Ukraine war not only re-enforced supply chain problems, but plunged the world, and Europe in particular, into the most severe energy crisis since the 1970s. The general inflationary trend, which had its origins in the Corona crisis and was assessed by central banks as temporary, was driven to its highest level since the 1980s by skyrocketing energy prices.

As a result, central banks around the world weighted the stability of the price level higher than economic growth and tightened their monetary policy to combat inflation, in some cases raising key interest rates aggressively. The central banks also made it clear to the markets that they take their mandate to ensure price stability seriously and will accept lower GDP growth rates or a recession if necessary. As a result, interest rates in the USA and Europe are higher than they have been for years, and economic growth has cooled noticeably.

Record high inflation and the associated sharp rise in interest rates have led to a sharp correction in share prices worldwide. The MSCI World All Country Indices (MSCI ACWI) closed the year down 18.36% and the MSCI Emerging Markets down 19.94%. The markets in Europe also showed a negative price development. The negative performance of European markets ranged from minus 6.97% (CAC 40) to minus 14.29% (SMI). The only exception was the British stock index FTSE 100, which ended the year 2022 with a plus of 4.31%.

Likewise, most other asset classes, except commodities, ended the past year in the red. At the sector level, the technology sector, which measured by the technology index NASDAQ, lost about 33% was one of the biggest losers. In general, growth stocks were among those most negatively affected by the sharp rise in interest rates, as central bank policies to combat inflation are a key driver of equity returns. Rising key interest rates increase financing costs for companies and the discount rate for future earnings, which weighs on valuations.

As there is an inverse relationship between interest rates and bond prices, the significant rise in interest rates worldwide weighed heavily on bond markets. For example, European government bonds with a maturity of 5 - 7 years suffered one of the biggest losses since the beginning of the monetary union. Likewise, US government bonds with this maturity recorded one of the biggest losses in at least 30 years. Emerging market bonds, which are particularly sensitive to interest rate changes and a fixed US dollar, suffered even more in 2022. This negative performance is common to all categories of bonds.

Global Economy

Let’s get the cat out of the bag: we and our research partners are aligned in the view that a recession with all its consequences will likely occur in 2023. Recessions almost always follow when interest rates are above nominal potential GDP growth and indicators such as manufacturing and services PMIs are in a clear downtrend (see Chart 1).

While it is true that inflation is slowing down, and this will certainly not escape the central banks either, we don’t see how a recession can be avoided without interest rate cuts. Even when there are no further rate hikes, the monetary policy is already in tight territory and will have its effects on the course of the economy. Central banks will be reluctant to cut rates as long as inflation is not coming down faster and the unemployment rate is not reacting quicker to the tightening.

One could argue that increased aggregate demand could help, when inflation comes down and real wages therefore stay high for a while, but the central banks would most likely see this as a negative sign for their goal of price stability and tighten even further.

However, we expect the coming recession to be a mild one. Why? Because there is no extraordinary economic shock (yet) that would establish a severe recession scenario as we have seen during the financial crisis of 2008/2009 or the 1973 oil crisis. Furthermore, private sector debt is not as big a problem as it was in the past: especially US households have largely deleveraged their balance sheets in the last decade. Another point is the excess savings households have built up during the pandemic.

Equities

As we have argued before, we are not convinced that the markets have even priced in a mild recession yet. If we look at the US, earnings have not yet adjusted enough to be consistent with a recession scenario. Scenario analysis has shown that an upside case would need the 10-year treasury yields to come back to below 2% for the S&P 500 to end on higher levels during a recession scenario as it is today, which we find unlikely if the recession turns out to be relatively mild.

The recent outperformance of cyclicals over defensive sectors is not consistent with a recession scenario, therefore we keep our sector recommendations in that regard. Also on the mid term falling interest rates in a recession would favour growth over value and large caps over small caps.

Furthermore we expect global equities ex-US to underperform, but especially Europe could catch up if Chinese growth surprises to the upside.

We expect China to go through easing policies in 2023, but whether this will merely stabilize the situation or boost the economy, has yet to be seen. For now we remain cautious regarding China related assets.

Fixed Income

Considering our stance towards short term interest rate prospects, it is not clear whether we have seen bond yields’ peaks yet. However, if we are right and we are heading into a recession in 2023, it will require interest rate cuts sooner or later to improve economic conditions again.

A dovish turn will bring yields down and prices up on the longer term horizon. So while investors might still be in for some future losses, it is a reasonable stance to have a certain position in the bonds market.

We expect the correlation between bond and stock prices to come down again, which would make the diversification effect of bonds more attractive again.

In our view, 2% is a likely floor for the 5-year and 10-year Treasury yield in a mild-to-average recession

Commodities and Currencies

In accordance with our mild recession view, we expect oil to move higher in the beginning of the recession, but to trade sidewards afterwards due to a combination of weaker oil demand and tight supply controls.

As mentioned many times before, industrial metals will largely depend on whether China can boost its economic growth again in 2023.

Regarding gold, we have seen that inflation was not the driver of gold prices in the recent past, but rather an inverse relationship to the dollar and real interest rates. What helped the gold price in 2022 was the geopolitical risk situation. Therefore, we recommend a modest positioning in gold only as long as the conflict in Ukraine is not resolved, and any major diplomatic breakthrough should make investors alarmed about their gold position.

Regarding currencies, and especially the US dollar, we expect that a recession will first drive the dollar up. But since the bond yields are higher in the US than the euro area for example, a decline in yields would harm the US dollar in comparison to the Euro.

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