While our broad asset class views remain somewhat defensive, we have shifted our regional and subsector views to express a glint of optimism about where conditions are headed later in 2023. We maintain our moderately underweight view on global equities, as we don’t think valuations adequately reflect recession risk. But given our improved outlook for China and EM ex-China, we have raised our views there to moderately overweight and neutral, respectively. We have reduced our view on US equities to a moderate underweight and maintain our overweight view on Japan. We remain more negative on Europe, where consumers are still bearing the weight of high energy prices and domestically driven inflation, and where earnings downgrades may have further to go.
Turning to fixed income, we are neutral on duration overall and favor US rates over Europe and Japan. The Fed is leading the way on the inflation fight while the European Central Bank (ECB) has relatively more work to do. With US growth slowing, we think 10-year yields in the 3.5% – 4% range look relatively attractive and believe high-quality fixed income will resume its diversifying role. As for spreads (growth fixed income), we maintain our underweight view. Recession has historically led to poor credit returns on average and median spreads point to a poor risk/reward trade-off, even in a more benign economic scenario.
The risks to our generally defensive view include upside from a soft-landing scenario or a more effective exit from China’s zero-COVID policies. In both scenarios, however, the inflation problem doesn’t go away. In fact, it may get worse, leaving policymakers, if we take them at their word, an even more hawkish bunch.
Equities: Policy weighs on earnings but looks supportive for EM and Japan
We expect inflation to decline but remain above target in 2023, allowing central banks to stop tightening but not to cut rates. As noted, we think the market is leapfrogging straight to a recovery and underestimating the effects of restrictive policy on the economy and earnings. The breadth of equity earnings downgrades has accelerated in recent weeks and expected margins have peaked. We expect further deterioration in macro variables to weigh on earnings expectations and don’t believe this outlook is adequately reflected in current equity valuations. We will need to see the downgrade process play out before we turn more favorable on global equities.
We expect a bumpy reopening in China as supply disruptions caused by absenteeism and strains on the health care system are all but inevitable. But we think consensus still underestimates the likely improvement in growth and inflation in 2023 as pent-up demand is released and financial conditions ease, with positive impacts on consumer-facing sectors in particular. We expect other emerging markets to benefit from China’s improvements, as well as from less of the sticky forms of inflation (wage- and shelter-driven) that we see in developed markets, providing room for less-restrictive policy. Emerging markets are pricing significant earnings declines for 2023, which, in contrast to developed markets, gives us more comfort that the worst might be over for equities.
We funded our move to a neutral view on EM ex-China by reducing our US view to moderately underweight. The growth and inflation backdrop in the US remains problematic and fiscal policy is more of a drag than in other regions; however, this growth backdrop is not reflected in valuations or earnings expectations. We also retain an underweight view on European equities as we think recession is still underpriced when it comes to company revenues and earnings — with real revenues expected to grow 2.1% in 2023. Energy price declines have provided some relief, but risks are skewed to the downside as we expect supply shortages to persist through at least 2025 – 2026. Most importantly, with sticky core inflation in Europe, we think policy tightening risk is highest there, creating greater downside for financial conditions than in other regions.
The investment thesis for Japanese equities remains attractive, with cheap valuations, a relatively more benign macro environment, and supportive fiscal and monetary policy. We are closely monitoring the Bank of Japan (BOJ) exit from yield curve control, which we believe will happen gradually over the course of 2023. The structural case for stronger Japanese growth remains intact, in our view, with a more dynamic labor market, a surge in capital investment, and a large exposure to China’s exit from zero-COVID.
Commodities: Focused on copper and oil
We have upgraded our view on copper to moderately overweight. Inventories of copper and other industrial metals continue to drift lower, and we expect a significant increase in copper demand from China in the coming months thanks to the zero-COVID exit and incremental support for housing. Copper is very sensitive to demand from China, which accounted for 54% of global demand in 2021.1 On a more structural basis, copper is likely to see acceleration in demand globally from the renewables, grid, storage, and electric vehicle supply chains as a result of the decarbonization process.
We maintain our overweight view on oil, where the roll yield remains positive despite recent declines. One driver of the recent oil price decline was the plan to cap the price of Russian crude at US$60, which we continue to monitor. But with the oil price currently just above marginal cost assumptions, we believe it still constitutes good value.
Fixed income: Expecting a better year for returns in the US
With the BOJ having effectively joined the hiking pack, all developed market central banks are now raising rates, reducing global liquidity, and slowing their economies. Yet conditions vary quite a bit from one region to another. In the US, markets have priced in the Fed’s current terminal policy rate of 5%, so we feel comfortable that 10-year yields of 3.5% – 4% are reflecting slowing growth and inflation in the longer term. Despite market optimism about rate cuts by year-end, we think it's more likely the Fed will need to hike rates further or keep restrictive policy in place longer to truly slay inflation, making recession more likely and lowering long-term yields.
The ECB adopted a more hawkish stance in December as the energy shock moderated and fiscal support proved to be a powerful offset. With core inflation high, wage pressures growing, and China’s reopening potentially fueling upside demand risk, ECB President Christine Lagarde offered this warning: “Compared to the Fed, we have more ground to cover, we have longer to go.” Thus, we are bearish on European sovereign rates. While the BOJ’s looser yield curve control is an important step toward exiting quantitative easing, we see the process as moving gradually and think any rate rise will be contained.
As for spreads, valuations are at median levels and therefore not reflective of worsening credit conditions, even in a mild recession. For example, global high-yield spreads have averaged around 1,000 bps in the past three recessions and spreads are currently close to half that. Furthermore, tighter lending standards of late are suggesting wider spreads (Figure 2).
Setting aside our underweight view on spreads broadly, we favor a quality bias. One way we see to potentially express a quality bias without giving up yield is to favor EM sovereign debt (USD-denominated), about 50% of which is investment grade, over high yield. Our research indicates that EM debt has historically had a lower beta to global equities than high yield.