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From a macro and market standpoint, the worst may be behind us, but we think it’s too early to wave the all-clear flag for risk in 2023. Tight financial conditions will be a headwind for most developed economies as central banks fight to bring inflation down, and we expect recessions in the US and Europe, though the severity is an open question. As suggested by the sharp rally in the fourth quarter of 2022, however, markets appear to be skipping the recession chapter of the story and moving straight to rate cuts and the benefits to risk assets. But even mild recessions mean negative earnings growth and pressure on equities and credit spreads.
Our outlook is a bit brighter when it comes to China and other emerging markets (EM). While we acknowledge the very real health risks that come with relaxing zero-COVID policies, we believe this shift will eventually unleash tremendous pent-up consumer demand for services, just as we’ve seen in other regions, and that there will be positive spillover effects for the rest of emerging Asia and exporting countries in Latin America. Furthermore, we find that China equity exposure has had a low correlation to other equity markets (Figure 1).
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.
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.
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.
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.
Upside risks to our views include soft-landing scenarios, where the Fed (and other central banks) manages to decelerate the economy enough to moderate inflation without a significant impact on employment and consumption, avoiding recession. We could also see higher fiscal spending in the US, Europe, and China offset the drag from monetary-policy tightening. Lastly, the boost to global demand or to domestic consumption and services from China’s zero-COVID exit could be underestimated by the market.
Downside risks include the possibility that tightening financial conditions, operating with a lag, have a more negative impact on global employment, earnings, and output than expected, resulting in a deeper or lengthier recession. Other risks include a liquidity-induced financial accident that causes systemic risk across the market, such as what we saw in the UK pension crisis in 2022, and an escalation in the Russia/Ukraine war.
Central bank tightening still warrants caution on risk — We continue to focus on quality in developed market equities as recession still looms and earnings expectations remain too optimistic. We prefer companies with pricing power, long-term margin stability, and healthy balance sheets that can withstand inflationary pressures. We favor value-oriented sectors like energy and materials.
Favoring a slight shift in China and EM exposure — However painful the process, reduced COVID restrictions in China are likely to improve domestic conditions. We favor moving to a moderate overweight to China and expect a positive spillover effect from increased China demand to EM equities ex-China.
Seeking to take advantage of regional divergence through active management — Central banks are at different stages of policy tightening and China is actually easing policy now. We favor Japan for its still relatively loose monetary policy and better growth/inflation mix. Financials are likely to be the biggest beneficiaries of higher 10-year Japanese government bond yields. We think European equities remain vulnerable to drawdowns compared to the US and Japan.
Seeing more to like in bond yields than earnings yields — High-quality fixed income looks more competitive versus equities from a yield perspective and could offer upside and diversification as growth slows.
Seeking inflation protection — While demand destruction in developed economies is a headwind, a supply/demand imbalance continues to support commodities. We favor industrial metals, especially copper, now that China’s COVID restrictions are easing. We also think TIPS breakevens remain attractive, as do some real assets.
Approaching credit cautiously — Spreads are not particularly attractive given the higher risk of recession. That said, we see opportunities in structured credit, particularly in older-vintage non-agency residential housing, and in short-duration credit.
1Sources: Wood Mackenzie, JPMorgan; as of 30 November 2022
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