As the new year approaches, economic cheer is scarce on the ground amid a darkening economic outlook marked by recession and persistent inflation.
Inflation is high, interest rates continue to climb, growth expectations tumble, geopolitical tensions like the war in Ukraine and past fiscal policy errors like the UK’s mini-budget continue to weigh on financial markets.
Investors will have to remain cautions and look for the silver linings in 2023 as the world economy slows down.
A recession foretold
A painful squeeze is already under way for companies and households as the UK’s independent Office for Budget Responsibility (OBR) offered a bleak outlook, projecting a 1.4% gross domestic product (GDP) contraction in 2023.
An OECD forecast said that only Russia would suffer a bigger economic contraction than the UK in 2023 among the G-20 leading developed and developing economies.
UK GDP contracted by 0.4% between the fourth quarter of 2019 and the third quarter of 2022.
Read more: 2022: Year in review
The Bank of England warned that the UK is facing its longest recession since records began, with the economic downturn expected to extend well into 2024.
Companies have felt it in their balance sheets, with London-listed firms issuing a total of 86 profit warnings, more than in any third quarter since 2008, according consultancy EY.
The rise in warnings was driven by an increase in the number of warnings from consumer-facing companies, which rose almost three-fold year-on-year. The report revealed that 57% of warnings during the third quarter cited rising costs, while 23% were prompted by labour market issues.
Over 40% of FTSE (^FTSE) retailers and over 60% of the FTSE Personal Care, Drug and Grocery Stores sector issued a profit warning in the last 12 months.
“Central bankers won’t ride to the rescue when growth slows in this new regime, contrary to what investors have come to expect. They are deliberately causing recessions by overtightening policy to try to rein in inflation,” BlackRock said.
Read more: UK in recession until end of 2023, CBI warns
That makes recession foretold, according to the markets.
“We now expect the euro zone and the UK to have entered a recession in Q4 2022, and China to be in a growth recession. These economies should bottom out by mid-2023 and begin a weak, tentative recovery – a scenario that rests on the crucial assumption that the United States manages to avoid a recession,” analysts at Credit Suisse said.
In stocks we trust?
Higher interest rates are not good for stock prices. They increase the cost of capital, which discourages companies from borrowing and investing to expand their businesses.
Earning stocks growth tends to stagnate. There’s also a negative impact on discounted cash flow valuations, which can hurt high-growth stocks.
For stocks to be the better investment, investors will need to be compensated for the extra risk.
“At a time when calamitous events are in the headlines on an all-too-regular basis, investors will enter 2023 with many questions about the strength and purpose of the political and financial institutions that support global markets,” Iqbal Khan, president of UBS Global Wealth Management, said.
The global wealth manager said 2023 will be a year of inflections and is favouring defensive sectors, income opportunities, “safe havens” and alternatives as themes investors should pursue.
Defensive sectors such as consumer staples and healthcare should prove relatively insulated from lower economic growth expectations, while value stocks tend to perform well in environments of high inflation.
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UBS GWM said more attractive opportunities to buy cyclicals and growth stocks may emerge later in the year as markets start to anticipate lower inflation and stronger economic growth.
Value stocks outperformed growth stocks by 18 percentage points in the first 10 months of 2022 and are predicted to continue this trend next year.
For example, the energy sector is benefitting from higher oil and natural gas prices as a result of the Ukraine war.
Investors can also look to the US dollar and the Swiss franc as shelter. “Relatively high US rates and slowing global growth should help keep the dollar strong in the coming months, and the Swiss franc’s safe-haven appeal is likely to attract inflows,” UBS GWM (UBS) said.
Amid an uncertain backdrop, seeking more predictable returns from income strategies should also be on investors’ radar, with UBS GWM focusing on higher-quality credit issuers.
As central banks ratchet up interest rates to contain inflation, high-grade bonds are starting to give stocks a run for their money, according to Goldman Sachs (GS).
Bonds — the biggest losers of 2022 — could be the biggest winners in 2023.
As bond yields reset at higher levels, inflation peaks, and central banks stop rate hikes, emerging market hard currency sovereign bonds, US government bonds, investment grade corporate bonds and selected yield curve steepening strategies look interesting to Credit Suisse (CS).
“Higher yields are a gift to investors who have long been starved for income. And investors don’t have to go far up the risk spectrum to receive it. We like short-term government bonds and mortgage securities for that reason. We favour high-grade credit as we see it compensating for recession risks,” BlackRock (BLK) said.
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“On the other hand, we think long-term government bonds won’t play their traditional role as portfolio diversifiers due to persistent inflation. And we see investors demanding higher compensation for holding them as central banks tighten monetary policy at a time of record debt levels,” BlackRock added, warning that there is a new regime playing out meaning that “what worked in the past, won’t work now.”
BlackRock’s new playbook argues that navigating markets in 2023 will require more frequent portfolio changes.
“The case for investment-grade credit has brightened, in our view, and we raise our overweight tactically and strategically. We think it can hold up in a recession, with companies having fortified their balance sheets by refinancing debt at lower yields.
“Agency mortgage-backed securities — a new tactical overweight — can also play a diversified income role. Short-term government debt also looks attractive at current yields, and we now break out this category into a separate tactical view,” it said. For now, it is staying away from long-dated bonds.
An overweight in high-rated bonds can provide diversification, and bond yields already price in a lot of tightening.
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US investment grade corporate bonds yield almost 6%, have little refinancing risk and are relatively insulated from an economic downturn, Goldman Sachs said.
“Although rising interest rates have created near-term pain for investors, higher starting interest rates have raised our return expectations more than twofold for US and international bonds,” Vanguard said.
“We now expect US bonds to return 4.1%–5.1% per year over the next decade, compared with the 1.4%–2.4% annual returns we forecast a year ago. For international bonds, we expect returns of 4%–5% per year over the next decade, compared with our year-ago forecast of 1.3%–2.3% per year.”
Investors can also lock in attractive real (inflation-adjusted) yields with 10-year and 30-year Treasury inflation protected securities (TIPS) close to 1.5%.
“Overall, 2023 will be a good year for income investing,” Andrew Sheets, chief cross-asset strategist for Morgan Stanley Research (MS), said.
Emerging opportunities in emerging markets
Although US equities have continued to outperform their international peers, the primary driver of that outperformance has shifted from earnings to currency over the last year.
“The 30% decline in emerging markets over the past 12 months has made valuations in those regions more attractive. We now expect similar returns to those of non-US developed markets and view emerging markets as an important diversifier in equity portfolios,” Vanguard said.
Read more: Energy companies drive global dividend payments to record high
HSBC is also looking at emerging markets (EM) with interest. “Emerging market economies are now much more resilient to global challenges and EM corporate fundamentals are at the strongest level in over 10 years,” the bank’s investment arm said.
On average, EM corporate bonds provide a yield of 8.7% and have an investment grade rating of BBB.
On a regional basis, HSBC prefers Brazil, Mexico and the GCC which have demonstrated “more economic resilience” in the current global environment.
When will central banks cut rates?
Most investment banks believe inflation has peaked in most countries as a result of decisive monetary policy action. But central banks are signalling that they need to hike rates further to reduce demand and tackle a labour market that is running hot.
“We see central banks eventually backing off from rate hikes as the economic damage becomes reality. We expect inflation to cool but stay persistently higher than central bank targets of 2%,” BlackRock said.
In the US, markets are now pricing in a more dovish Federal Reserve, signalling an expectation that the US central bank will begin lowering its funds rate by the end of next year. But some believe there will not be any rate cuts in 2023.
“Although we expect the pace of tightening to peak by the end of 2022, we do not forecast any developed market central banks to cut interest rates in 2023,” Credit Suisse said.
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For JP Morgan Asset Management (JPM), assuming headline inflation and wage inflation are easing, it sees US interest rates rising to around 4.5%-5.0% in the first quarter of 2023 and stopping there. The ECB is similarly expected to pause at 2.5%-3.0% in the first quarter.
“The Bank of England may take slightly longer to reach a peak, given that inflation is likely to prove stickier in the UK. We see a peak UK interest rate of 4.0%-4.5% in the second quarter,” it added.
Beating back inflation
Investors may find themselves whiplashed in 2023 as inflation hits multidecades highs. As German economist Karl Otto Pohl put it, inflation is like toothpaste; once it’s out, you can hardly get it back in again.
“The fear is that monetary policy alone cannot tame this self-sustaining inflationary environment. Even Christine Lagarde, the head of the European Central Bank, admits that the world ‘will not return to the low-inflation environment’ of before the pandemic,” Neil Wilson, chief market analyst at Finalto, said.
“Markets are hooked on the idea of a pause or a pivot and when that might be. This is the wrong way to look at it. AsFed governor Christopher Waller said: ‘Quit paying attention to the pace and start paying attention to where the endpoint is going to be. Until we get inflation down, that endpoint is still a ways out there’.”
Despite the grim outlook, there are still opportunities for investors to beat prices.
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“I expect 2023 will be tough for households and businesses. But my central case is that it could be better for investors,” Tom Stevenson from Fidelity International said.
Morgan Stanley is favouring value plays in Europe, where stocks in the banks and energy sectors offer above-average dividend yields.
It said: “We think that this is an exceptional environment for generating high single-digit returns from high-quality assets, an opportunity that hasn’t presented itself for a long time.”
The investment bank’s 2023 outlook highlights the potential of buying early cycle emerging market and Japan equities for 11-12% returns.
Overall, investors will need to be more tactical and pay close attention to the economy, legislative and regulatory policy, corporate earnings and valuations, said Mike Wilson, chief investment officer and chief US equity strategist for Morgan Stanley.
“Because we are closer to the end of the cycle at this point,” Wilson said. “Trends for these key variables can zig and zag before the final path is clear. While flexibility is always important to successful investing, it’s critical now.”