| 2022 was a tough year for investors globally, the worst since 2008 during the financial crisis. Most major asset classes fell sharply, which meant there were no hiding places. Even cash was impacted by decades high inflation which eroded real value. Equity markets had a torrid year, with many registering double-digit declines.To make matters worse, bond markets added to the pain, with some seeing their biggest losses in history. Normally these two asset classes do not move in the same direction at the same time, which helps to diversify asset allocation, mitigate investment risks and cushion losses. This was not the case in 2022.
The most notable cause of this unusual set of circumstances can be summarised in one word, Inflation. The actions taken by Central Banks to curb 40-year high inflation, the impact that this action had on interest rate policy and the volatility created by excess inflation leaking into the world economy due to the war in Ukraine and the actions of the Chinese Government to fight Covid, all combined in a perfect storm that undermined investor confidence as liquidity was forcefully withdrawn from the global economy as Monetary Policy was tightened.
History cannot be altered but it can give us valuable insight into how matters may develop in the future. In certain ways, it may well be more of the same in the early part of 2023, as Monetary Policy enacted by Central Banks will continue to determine volatility and the direction of markets. Central Banks will continue to review the success of their monetary tightening in 2022 and will have to decide how much further they have to go to get the inflation Genie firmly back in the bottle. On the positive side, the data coming through in the last quarter of 2022 does indicate that inflation may have peaked in the US, the UK and Europe.
A global economic recession looks to be the likely outcome of the cost-of-living squeeze and the actions taken by Central Banks in 2022. All that is in question is the severity of the recession in different economies. The International Monetary Fund (IMF) recently reported that they expect a third of the global economy will be in recession in 2023. The hope is that we will see a short, mild recession but only time will tell if that will be the reality. What is important to realise is that stock markets and economies move in different cycles from one another. A Bear Market in stocks (a period where an individual stock or an index has fallen in value by more than 20% from its most recent high) has historically lasted 14 months in the US and does not normally reach a bottom until after a recession in the economy begins but before a recession ends. If we use the S&P 500 in the US as an example, the bear market in the S&P 500 started in January 2022, therefore the current bear market looks like being close to a conclusion at some point towards the end of Quarter 1 of 2023, if the historical pattern is repeated. If we work on the basis that we are closer to the end than the beginning of the stock market realignment, what does 2023 offer in investment terms?
If the data coming through on inflation continues to point to receding inflationary pressures from the second half of 2023 then Central Banks will have the ability to support economic growth to try and minimise the impact of recession. This would be done by bringing to an end the interest rate hiking cycle, which could potentially happen by the end of Quarter 2 in 2023, if not earlier. The caveat here is that the inflation outlook is difficult to predict, as changed circumstances in Ukraine or with the Covid policy in China may undermine this base scenario. If central banks do become concerned by a downturn in economic momentum, then they may be willing to accommodate a slightly higher rate of inflation of between 3 – 5% to be able to prevent making a recession any worse.
The sizeable pullback in values that occurred in 2022 means that equity valuations look to be more attractive in the UK, Europe and Asia rather than the US, where they still look relatively expensive. The upcoming recession has been well predicted and valuations have taken the brunt of the repricing through 2022. As long as corporate earnings are not impacted any more severely than already predicted, the outlook for this asset class, especially in value stocks, looks positive for 2023.
Bond valuations, which really suffered in 2022, now look very attractive in valuation terms and have not looked this cheap relative to equities since the 1990’s. Bonds and Sovereign debt are offering more income now than they have in over a decade, which also makes them attractive where inflation and interest rates may be moving downwards. Default rates are pricing in a worse picture than the likely reality as corporate balance sheets are not as weak as the default rate would indicate. Selective investment in this area still make sense to allocate to high quality and more defensive names in this sector.
Global Real Estate will also face challenges as occupiers look for buildings with Green credentials. Properties without the necessary infrastructure that supports sustainability will potentially face lower occupancy rates and inevitably may have to be retrofitted at high cost, which will put a significant squeeze on property yields. Inevitably property valuations will stabilise but that may take some time to occur.
Geo-Political risks will continue to create volatility in 2023. The ongoing conflict in Ukraine will remain the most obvious headwind to normalised business operations and trade flows, never mind the devastating impact it is having on the Ukrainian people. Any indication of a move towards a negotiated settlement would have an immediate and extremely positive impact on investment sentiment. The rebuilding of Ukraine would also be a massive tangible stimulus to the global economy going forward.
US – China tensions look set to continue, especially with the recent comments coming from Beijing about Taiwan being reunited with China. There is also an expectation that China will respond to the technology curbs introduced by the US.
Summary
In order for progress to be made this year we need to see a combination of factors align positively. Inflation has to be confirmed as having peaked and then be seen to be coming down at some point in the year. This will give Central Banks the scope to end the hiking of interest rates. This in turn would allow for support for the global economy once interest rates start to be reduced and financing costs start to fall, which should assist in moderating the impact of the expected global recession.
Any signs of resolution in Ukraine would be the final element that would help to underpin a recovery in the global economy. The lifting of some sanctions and the implementation of an infrastructure redevelopment in Ukraine would be a huge boost to investor sentiment and remove one of the major uncertainties that has been a significant headwind for the world economy. |
