Investing in 2023: Time for a little more optimism
- There are several themes that could support markets in 2023 - inflation should ease further
- The potential impact of China’s reopening on the domestic and global economy could be significant
- There is potential for vast, green-related infrastructure investment
The challenges faced by markets in 2022 – the Ukraine crisis, inflation, rapidly tightening monetary policy and slower economic growth - are unlikely to retreat anytime soon; the threat of further market volatility is a constant.
Last year’s problematic environment witnessed negative returns from both bond and equity markets; this was unusual, and it would be even more unusual to see a repeat of these returns in 2023.
So, despite the tough macroeconomic backdrop we believe there are reasons for investors to be optimistic as 2023 gets into gear. There are several themes that could support markets in 2023. These include disinflation, stable-to-lower real bond yields, China’s reopening and increased spending on infrastructure and green assets.
Greater market positivity
After a tumultuous 2022, investors enjoyed some respite in the fourth quarter (Q4) as markets rallied in the hope that anxieties over inflation and rising interest rates appeared to hit a peak.
Thankfully this is a trend which, so far at least, has spilled over into the early days of the new year; major US, Asian and European indices are all in positive territory year-to-date – the UK’s FTSE 100 has even crossed 7,700 for the first time since 2018.1
Markets have been bolstered by a better news flow which has seen Q3 US economic growth stronger than first estimated, beating expectations and confirming a strong rebound from Q2’s contraction. In the three months to end-September US GDP was up an annualised 3.2% against an initial projection of 2.9%, revised upwards on the back of improved consumer spending and fixed investment.2
Despite the recent rally – and given the hit risk assets took in 2022 – there is potential for further gains. Equities have plenty of space to rebound while bonds, following the significant repricing of all fixed income assets last year, are presently much more attractive given the typically higher yields on offer.
Increased inflation which defined 2022 should begin to ease this year. But while we expect inflation to edge back, we anticipate that it shall do so slowly. Recent numbers have been encouraging, with several countries looking like they are at peak-inflation. In the US inflation eased further, to 6.5% on an annual basis in December, from 7.1% in November - the slowest annual increase since October 2021. And if the monthly increase in the Consumer Price Index matches the historical average for each month until the end of 2023, then headline inflation in the US might even get back down to between 2% and 3%.3
In addition, in the Eurozone, inflation is finally back in single-digit territory, with the annual rate dropping to 9.2% in December from 10.1% in November – and while still elevated, it represents a sharper slowing than expected by markets.4 Separately, the Eurozone’s business activity woes eased in December, reflecting lower inflation, a resilient labour market and a rise in business confidence, suggesting that any recession will likely be quite shallow. Historically, equity returns have been better when inflation reverts to more comfortable levels.
Forget the Fed
Federal Reserve Chair Jerome Powell has been very clear in his messaging; the Fed will maintain its hawkish stance until inflation is meaningfully lower. In our view this indicates one or two hikes and no cuts in 2023. But we don’t think the market is convinced. That is why the yield curve – a line which plots interest rates for bonds that have equal credit quality, but different maturity dates - is inverted, i.e., bonds of longer maturities provide a lower yield, reflecting investors' expectations for a decline in long-term interest rates. Following the Fed’s last meeting the estimate of the long-term equilibrium interest rates remained at 2.5%.5
The market simply does not believe the Fed can keep the overnight interest rate at double the long-term equilibrium rate for any prolonged period. The first half of 2023 should see the peak in central bank interest rates. This in itself should be positive for markets, with investors potentially able to benefit from the highest bond yields for many years. Shorter-duration credit and high yield fixed income assets look the most attractive in this environment.
China’s reopening following its pandemic-induced lockdown is certainly significant. The world’s second-largest economy has been enduring its slowest growth rate for decades.6 With its borders once again open investors will be hoping to see a return to growth and investment returns.
Certainly, the potential impact on the domestic and global economy could be significant. Notably, since the market lows of 2022, Chinese H-shares (those listed in Hong Kong) and Asian high yield bonds have staged a dramatic rebound. In addition, China’s ongoing easing of monetary policy and mild inflation offer room to support its growth recovery.
The implications of China’s reopening spread well beyond its borders, into wider Asia and around the world, especially Europe - and the potential uplift from a reinvigorated export market, domestic services and consumption could be very powerful. There is also the potential that increased Chinese activity will put renewed pressure on energy markets and limit the extent to which inflation can come down globally. However, the positives from increased Chinese demand and easier supply chains should be more important than any potential inflationary implications from a stronger Chinese economy.
But investors need to brace for a rocky road ahead. The sudden reversal of its ‘Zero-Covid’ policy has spurred on a mass wave of infections which is overwhelming hospitals. However, once the disease has passed through the population, especially if vaccination levels rise, then the $17.7trn economy should enjoy a bounce on the back of higher consumption, private sector investment, as well as increased volumes of foreign trade and travel, and a potential recovery in China’s beleaguered property market.7
ESG to regain its traction
Last year’s United Nations climate change conference COP27 fell short on many fronts, but the climate agreement delivered on a breakthrough ‘loss and damage’ fund, designed to help vulnerable countries contend with the devastating effects of climate change. However, a key takeaway from the summit is that investors are central to any viable plan to finance our transition to a more sustainable era.
The pathway to net zero and beyond is still clear even if this latest meeting has failed to smooth out the bumps as it might have. Encouragingly in December, 195 countries agreed to protect and restore at least 30% of the world’s land and seas by 2030 in a landmark deal announced at the COP15 biodiversity conference. The agreement also encourages countries to channel $200bn each year to biodiversity initiatives.
More broadly, the Ukraine crisis has firmly put the spotlight on energy security; now more than ever steps are being taken to secure energy supply, which in turn is further encouraging speedier development of renewables. The Inflation Reduction Act, passed by the US Congress last year, opens up the potential for huge, green-related infrastructure investment in the US. Government subsidies in sectors such as electronic vehicles, carbon capture and hydrogen production will boost overall US investment in the energy transition. This will have powerful implications for many sectors in the US equity market.
Fundamentally, the momentum driving the need for sustainable business practices is here to stay – and what is clear to us is that sustainable investment is the only way to ensure the future strength of the global economy.
Uncertain road ahead
While we believe there are reasons to be optimistic this year, 2023 will still be far from plain sailing. We know recession is here – and the International Monetary Fund (IMF) anticipates that one third of the world economy will be in recession over the coming 12 months.8 However, a slowdown is baked into the outlook and investors have priced this in.
But we do expect inflation to subside, and that economic activity will start to improve as we move through 2023 and into 2024 - and with market valuations now more attractive there is potential for a more robust, if unsteady, rebound.