Investment Outlook 2023
Trials, challenges and opportunities?
Investment Outlook 2023
Trials, challenges and opportunities?
The value of investments can go down as well as up, your capital is a risk.
maCROECONOMICS
recession
earnings
asset classes
net zero
1
2022 – Inflation testing the resolve of politics and central banks
Rising inflation and interest rates made 2022 one of the most challenging years for investment returns in the last 40 years. Political shocks of Russia’s invasion of Ukraine, China’s zero-Covid policy, UK pension funds and FTX’s bankruptcy all played a part in increasing uncertainty further. Throughout the year, a sequence of inflation, then stagflation and finally recession fears developed that sent asset returns across the board into negative territory.
TURBULENCE ON THE HORIZON
“Central banks worried about their inflation fighting credibility and became preoccupied with ‘breaking the back’ of inflation by hiking rates, although some took a more aggressive approach than others,” said Mohammad Syed, Head of Asset Management at Coutts.
Soaring prices were exacerbated by the Russia/Ukraine conflict and China’s continued Covid restrictions – all key producers of commodities or goods. Syed added: “Much of this feels like a once-in-a generation alignment of events, which has caused historically rare market dynamics.”
TURBULENCE ON THE HORIZON
“Central banks worried about their inflation fighting credibility and became preoccupied with ‘breaking the back’ of inflation by hiking rates, although some took a more aggressive approach than others,” said Mohammad Syed, Head of Asset Management at Coutts.
Soaring prices were exacerbated by the Russia/Ukraine conflict and China’s continued Covid restrictions – all key producers of commodities or goods. Syed added: “Much of this feels like a once-in-a generation alignment of events, which has caused historically rare market dynamics.”
NO DIVERSIFICATION BENEFITS IN 2022
MULTI-ASSET PORTFOLIOS’ BIGGEST DRAWDOWN IN DECADES
The decline in performances for both bonds and equities saw any typical 60% equities/40% bonds portfolio fall by its largest amount in over 40 years – worse than the Global Financial Crisis and the 1973-1974 oil shock. The chart below shows how historically reliable these portfolios have been for investors, and the rarity of the 2022 outcome.
Of course, you shouldn’t rely on past performance as an indicator of future returns. The value of investments can go down as well as up and you may not get back the initial amount you invested.
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With interest rates rising, the 10-year Treasury yield has climbed 3.5% over two years – a move rarely seen since World War II.
“Although some monetary tightening was expected at the start of 2022, markets didn’t foresee the aggressive policy shift of central banks and the significant rise in bond yields,” said Syed. “It seems that bond markets have been driving down equity markets, so the usual bond-equity diversification benefits did not materialise last year.”
SIMULTANEOUS DECLINE OF ASSET CLASSES
The defining feature of 2022 was the simultaneous sell-off experienced across asset classes (see chart below). This was a result of rising inflation creating concerns around stagflation, which then morphed into recession fears – all in one year. Seeing as no mainstream asset performs well in all three of these environments, investors had nowhere to hide.
Source: Datastream
All bond returns are hedged unless stated otherwise
2023 – A STORY OF TURNING POINTS
The complex mix of geopolitics and slowing economics will continue to be part of the 2023 story. Recessionary fears and declining corporate earnings will likely start the year in a volatile manner. But as the year progresses, market dynamics and central bank policy could turn more positive and create a more constructive investment environment. Ultimately, investors should stick to their long-term investment plans in our view, and retain market exposure to participate in the inflection dynamics.
2
Global growth to slow further in 2023
recession on the cards
Many western economies will likely be in recession this year – where the region’s economic activity shrinks for two or more consecutive quarters. In Europe this will mostly be a reaction to the energy shock, while in the US it’ll be a reaction to its rapid hike in interest rates.
recession on the cards
Many western economies will likely be in recession this year – where the region’s economic activity shrinks for two or more consecutive quarters. In Europe this will mostly be a reaction to the energy shock, while in the US it’ll be a reaction to its rapid hike in interest rates.
the us
US economic momentum slowed yet remained robust in 2022. Real GDP growth was expected to be north of 2.6% by the end of the year, according to the Bureau of Economic Analysis, supported by consumer demand amidst record low unemployment. However the US Federal Reserve’s record monetary tightening will likely result in a recession starting in the first half of this year. Elevated interest rates are causing house prices to fall, and a decline in real purchasing power will eventually take its toll on consumers’ ability to spend – households are already having to resort to their savings – and cause GDP to contract.
europe
Europe was looking close to entering a recession towards the end of 2022, largely because of the energy shock driving up inflation and hitting consumers and businesses. While many governments have put in place fiscal policy to support individuals and business, inflationary pressures remain high and financial conditions can tighten quickly.
the uk
In the UK, with inflation in double digits, Prime Minister Rishi Sunak announced a relatively restrictive Budget in November. In the course of two months, the UK went from fiscal profligacy to austerity, which helped stabilise gilt yields. However, it’s striking that the UK backdrop is now characterised by weak growth, high inflation and higher interest rates and taxes. While the BoE has outlined its path to raise interest rates in the coming months, it will have to consider a balance between the state of the housing market, which impacts the economy, and inflation pressures. Ultimately we think the economy will turn itself around, but things will likely get worse before they get better.
3
Company earnings – the new fundamental driver of markets in 2023
Inflation was the most important macro-economic driver in 2022, but is likely to be less so this year. Slowing economic momentum will shift the focus to corporate earnings as the main fundamental driver of risk assets. Markets are forward looking and have at least partly priced in these trends already, but probably not sufficiently. Here are some of the earning trends for the US and Europe.
THE US – THE REBOOT OF TECH
The technology sector accounts for just under half of total US earnings. 2022 was on course to deliver zero earnings growth compared to 2021. And this year’s expectations aren’t any different.
so why the lack of growth?
THE LASTING IMPACT OF COVID-19
During the pandemic, there was a surge in demand for laptops, tablets, smartphones and consumer electronics as employees transitioned to working from home. Now, as normality resumes and staff return to the office, the demand for these goods begins to fade. Demand for PC units last year fell by nearly 30% compared to 2021, according to Bank of America. And Apple announced in its Q3 results that iPad sales had fallen by 13%.
TENSIONS WITH CHINA
China is a key source of demand for US tech companies, particularly for manufacturers of semiconductor equipment which services China’s chip making industry. However, US President Joe Biden has limited the exportation of certain tools to China in a bid to curb the use of high-end chips by Chinese military. This has hit the volume of business for US semiconductor manufacturers.
A SLOWING CORPORATE PROFIT CYCLE
Rising costs hit profits for US companies last year – contributing to falling estimates for overall US earnings growth. Inevitably, this will reduce the appetite for new investment in IT.
STRENGTHENING DOLLAR
Tech is the most internationally focused sector in the US, with just 42% of revenue coming domestically. And as the dollar surges this year against most other currencies, international earnings become worth less when converted back to dollars.
EUROPE – THE PRICE BALANCING ACT
The rising energy price crisis will add continued pressure on European company earnings as we enter this year. Europe relies heavily on exportation, with two-thirds of revenues coming from overseas. The issue comes as the majority of goods are produced domestically, creating a mismatch in costs.
Sufficient price increases must be passed through to customers to help cover rising input costs. If these increases are too low, margins won’t be optimal. If they’re too high, order volumes will fall and will impact revenues. Let’s also not forget other factors such as a natural drop in demand, increased transportation costs and mounting wage pressures.
POSITIVE NEWS ON THE HORIZON
So is it all doom and gloom? While some of these factors have been going on for some time, these headwinds shouldn’t persist, and the outlook will likely improve as the year progresses. For the US, the covid-19 related factors will likely fade and US companies should find a way to navigate Chinese market restrictions.
On a forward price-to-earnings basis, European equities currently trade on a 30% discount to the S&P 500. This is the widest figure since 2005. If inflation shows signs of coming under control and bond yields start to fall, the forward-looking nature of markets means we could see the unusual situation of markets decoupling from disappointing earnings prints.
POSITIVE NEWS ON THE HORIZON
So is it all doom and gloom? While some of these factors have been going on for some time, these headwinds shouldn’t persist, and the outlook will likely improve as the year progresses. For the US, the covid-19 related factors will likely fade and US companies should find a way to navigate Chinese market restrictions.
On a forward price-to-earnings basis, European equities currently trade on a 30% discount to the S&P 500. This is the widest figure since 2005. If inflation shows signs of coming under control and bond yields start to fall, the forward-looking nature of markets means we could see the unusual situation of markets decoupling from disappointing earnings prints.
4
Asset classes – what to keep an eye on
As mentioned earlier, the mix of recession and declining earnings, we think, could become the catalyst for important changes in monetary policy and financial markets. Asset class preferences will likely be sequential in 2023, starting with bonds and shifting to riskier asset classes later in the year. Here are three assets that could benefit from such a backdrop:
Government bonds
While the Fed will probably continue to raise interest rates at the start of the year, a recession should shift bond market dynamics. Given that the Fed is likely to change policy and potentially cut interest rates in response to a recession, the relation between stock prices and bond yields will likely revert to a more traditional dynamic where stock prices and bond yields decline due to or in anticipation of a recession. Hence, bonds could be supported by a change in narrative from combating inflation to fear of recession, and look more attractive again.
| During US recessions | 13.5% |
| 12 months after a peak in inflation | 10% |
| During recovery phases | 7.9% |
| Since 1978 (all periods) | 6.5% |
Source: Refinitiv, as at 30 September 2022
Emerging market equities
Emerging market equities haven’t performed well this year, partly down to the strong US dollar. While the dollar tends to strengthen during periods of monetary tightening and recession, it usually weakens during economic recoveries. Emerging market stocks should be one of the main beneficiaries of a dollar reversal this year.
| USD during recessions | 5.1% |
| USD post inflation peak | 5.2% |
| USD During recovery phases | -1.3% |
| USD Since 1978 (all periods) | 0.7% |
Source: Refinitiv, as at 30 September 2022
Small cap equities
This part of the market is usually seen as more sensitive to changes in the economic outlook. This is why we reduced our exposure last year as economic momentum slowed. However, a recovery in growth prospects could finally bring a better backdrop for the asset class. Since 1978, smaller companies have consistently performed well in post-recession periods when growth re-accelerated.
| During recessions | 4.1% |
| Post inflation peak | 13.4% |
| During recovery phases | 21.2% |
| Since 1978 (all periods) | 11.1% |
Source: Refinitiv, as at 30 September 2022
| During US recessions | 13.5% |
| 12 months after a peak in inflation | 10% |
| During recovery phases | 7.9% |
| Since 1978 (all periods) | 6.5% |
| USD during recessions | 5.1% |
| USD post inflation peak | 5.2% |
| USD During recovery phases | -1.3% |
| USD Since 1978 (all periods) | 0.7% |
Source: Refinitiv, as at 30 September 2022
| During recessions | 4.1% |
| Post inflation peak | 13.4% |
| During recovery phases | 21.2% |
| Since 1978 (all periods) | 11.1% |
5
Responsible Investing –
reaching carbon neutrality
THE WAY THE WIND’S BLOWING
The transition to Net Zero has been a key theme within our responsible investing approach and has highlighted some global dependencies that we will monitor in 2023.
In 2022 we started moving our funds and portfolios to align to a Net Zero trajectory. This means that a portion of our core funds and discretionary portfolios are invested in assets that are aligned to a Net Zero trajectory. We believe that actively managing the transition to Net Zero could help mitigate risk associated with climate change.
But taking this further, we want to achieve Net Zero emissions across our investments by 2050. We’ve set targets to increase the proportion of the underlying funds that are on a Net Zero trajectory and decarbonising year-on-year. As investors, there are two ways we can help move towards our goal of limiting global warming to 1.5°C:
1
Invest in companies that are producing climate solutions.
2
Use our influence to get key industries, such as energy, to reduce their emissions and scale up their investment in renewables.
The current global energy crisis has highlighted a continued dependency on fossil fuel-rich nations. To help reduce this dependency, countries might turn to cleaner energy alternatives, creating an encouraging policy environment. By hopefully accelerating the growth in renewables, this could create incentives for energy majors that rely on fossil fuels to diversify into cleaner energy sources.
And as for energy companies already working to align with the Paris Agreement, we’re encouraging them through engagement to speed up their transition into renewable energy.
We expect the global energy mix to be set for a shake-up in the next decade. Climate-minded investors that previously steered clear from fossil fuels could find opportunities to usher fossil fuel companies into playing a big role in speeding up the transition to Net Zero.
The energy industry, however, is just one example of how investors can drive and benefit from change simultaneously, by supporting the disrupters while nudging those that are lagging to transition and diversify to greener strategies.
Find the answers to your frequently asked questions about investing here.
