Monthly Investment Letter: Gauging the inflections

Markets are off to a solid start in 2023 as falling inflation, relatively robust economic data, and China’s COVID policy change drive investor hopes of a “soft landing” for the global economy.

The big question now is whether the latest activity readings and China’s reopening mean the current rally will prove durable, or if we face more volatility and uncertainty ahead.

In our Year Ahead report, we said that 2023 would be a “Year of Inflections,” with the timing and magnitude of turning points in inflation, interest rates, and growth shaping the outlook for markets. In this letter, we assess the progress of the key inflection points and the implications for positioning.

In short, the backdrop remains one of high inflation, rising rates, and slowing growth. But at the same time, labor market and inflation data in recent weeks has been encouraging, and we recognize that some parts of the market will reach inflection points before others, meaning dispersion between different geographical markets and sectors is likely to be elevated. We therefore think selectivity will be rewarded, and our positioning reflects that.

• For example, we think China’s reopening should allow for a faster turning point in global growth and prove supportive of emerging market equities and commodities. We have added a preference for both asset classes this month. Lower gas prices should reduce recession risks in Europe, and we have moved to a neutral view on the euro from least preferred. We have also added a preference for emerging market bonds relative to high grade bonds, given cooling US inflation and China’s policy shift.
• By contrast, still-tight labor markets in the US mean that investor and central bank concerns about inflation are likely to persist despite recent declines in price readings. In addition, we do not believe that US valuations fully reflect the earnings contraction we expect this year. The risk-reward trade-off therefore remains unfavorable for broad US indexes, in our view, and we retain a least preferred stance on US equities and the technology sector.
• Elsewhere, within equities, we continue to favor healthcare, consumer staples, and energy. In fixed income, we prefer higher-quality bonds, including high grade and investment grade, relative to high yield credit. In currencies, we have moved the Swiss franc down to neutral, have a most preferred view on the Australian dollar, and retain a least preferred view on the British pound.

Growth: Resilience so far, but divergence ahead

What’s happened?

In the US, consumer spending has continued to increase in real terms despite the impact of higher prices and interest rates on household budgets. Even after disappointing retail sales data for December, the Atlanta Federal Reserve’s GDPNow tracking estimate for consumption expenditures shows a 2.6% growth rate in the fourth quarter of last year.

In Europe, mild weather has allowed gas storage facilities to be filled, contributing to a fall in gas prices. Hard economic data, including industrial production, and sentiment surveys have also been stronger than expected.

And in China, Beijing has opted for a “big bang” exit from its zero-COVID policy, which will likely result in a peak in infections in major cities within weeks, and thus pave the way for a faster-than-anticipated economic recovery.

What do we expect?

From here, we expect to see a divergence in the growth trajectories for different regions.

The US economy is likely to slow further. The savings rate has fallen close to 2%, near its record low, suggesting limited capacity among consumers to continue to spend. The housing sector has turned sharply lower in response to higher mortgage rates: Existing home sales are down 35% year-over-year in November. Leading indicators also suggest weakness ahead: The ISM manufacturing PMI has been in contraction territory since November, and the ISM services PMI fell to 49.6 in December, the lowest reading since May 2020.

By contrast, growth in Europe is likely to accelerate in the coming months. Lower gas prices and fiscal support have helped cushion the downturn. We now see upside risk to our estimate that Eurozone GDP in the fourth quarter of 2022 shrank 0.4% from the previous quarter, and for the first three months of 2023, growth could be flat or even slightly positive. We expect a further improvement in the second and third quarters.

In China, the surge in infections and consumer caution are likely to dampen growth in the near term. But mobility data are pointing to increasing activity. Subway ridership, for example, rebounded rapidly in the first half of January, with the seven-day moving average reaching around 70% of 2020 levels based on our tracker. We expect a recovery in consumption and activity from February and a further acceleration from the second quarter onward. Beijing’s supportive monetary and fiscal policy stance and households’ pent-up savings should provide an additional boost. Overall, we expect GDP growth to recover to around 5% in 2023.

What does it mean for investors?

Until a trough for the US economy and global corporate earnings is more clearly in sight, we expect equity market volatility to continue. As such, we are selective in our equity allocations. Improvements in Europe and China create opportunities for investors.

We expect market volatility to continue and are selective in our equity allocations.

Since October’s low in global equities, emerging market equities have already outperformed US equities by 10 percentage points, but China’s reopening should enable this trend to continue. We move emerging market equities to most preferred and retain US equities at least preferred in our asset allocation.

We also expect China to outperform other regional markets in the months ahead. We estimate 13.8% earnings per share growth for MSCI China in 2023 compared with 6% for MSCI Asia ex-Japan.

In Europe, we move our view on the euro from least preferred to neutral. European Central Bank policymakers are likely to remain hawkish for some time as they aim to bring inflation all the way down to the 2% target. We also continue to like German equities, which should benefit both from improving growth in Europe and from China’s reopening, given the German market’s export-oriented composition.

Inflation: Falling, but how fast?

What’s happened?

Inflation has continued to fall from its peaks late last year, largely supported by falling energy prices.

US inflation fell to 6.5% year-over-year in December after 7.1% in November and 7.7% in October. Meanwhile, Eurozone inflation slowed to 9.2% year-over-year in December, down from 10.1% in the prior month, and surveys show that both input and output prices are now rising at their slowest rate for 12 months.

What do we expect?

The decline in inflation is already enabling central banks to slow, or discuss slowing, the pace of rate hikes. However, uncertainty remains about how smoothly and quickly inflation will fall back to target, most notably because of continued tightness in labor markets.

US nonfarm payrolls increased by 223,000 in December, around double the pace of growth in the workforce. The unemployment rate, at 3.5%, is at a 50-year low. And the JOLTS survey data showed job openings dropped by just 54,000 month-over-month in November to 10.46 million, meaning there are still 1.74 vacancies for every unemployed person. This is translating into high wage growth. The Atlanta Fed’s wage tracker shows the three-month rolling average of wage growth at 6.1% in December, and, with the quits rate high by historical standards, it is important to note that job switchers are achieving 7.7% wage growth.

In Europe, although headline inflation has fallen, core inflation has risen to a record 5.2%, and the ECB has highlighted that “wage growth over the next few quarters is expected to be very strong compared with historical patterns.”

What does it mean for investors?

Lower inflation is positive for markets, but at over 6% in the US, there is still a long way to go before investors, or central banks, can feel comfortable that inflationary risks are behind us. The risk is that price and wage inflation proves stickier than expected and does not fall smoothly back down to central bank target levels.

The risk is that price and wage inflation proves stickier than expected.

As a result, we retain a preference for value stocks relative to growth, given that value stocks tend to outperform during periods of elevated inflation, and growth stocks could be at risk if inflation proves to be stickier than we, or the market, expect in our base case.

We also think uncertainty about inflation speaks in favor of including a tactical allocation to commodities within portfolios. Commodities should benefit from increased demand following China’s reopening, but can also act as a portfolio hedge against inflation proving more persistent than expected.

Monetary policy: Peaks in sight, but cuts remain distant

Lower headline inflation has helped alleviate some pressure on central banks, and the Fed, ECB, and Swiss National Bank all shifted to a 50-basis-point pace of interest rate increases in December, after 75bps in their previous rate hikes. The Fed is widely expected to slow the pace of rate hikes further, to 25bps, at its next meeting on 31 January–1 February.

What’s the outlook?

Markets, economists, and policymakers have a fairly clear consensus about the likely peak for interest rates in the near term. Both the Fed’s “dot plot” and financial market pricing imply a further 50–75bps of interest rate increases before a peak. Federal funds futures currently imply that rates will peak around 4.95% in June, and most Fed officials expect a peak between 5% and 5.25%.

However, the timing of future rate cuts is much more uncertain. Market pricing suggests the Fed will bring rates back down to 4.5% by the end of 2023, yet the minutes of the Fed’s December meeting showed no policymaker backing rate cuts until 2024. In verbal comments, central bankers have also continued to push back against the market’s pricing of a more dovish future policy stance. Atlanta Fed President Raphael Bostic said interest rates should stay above 5% for “a long time,” adding he was “not a pivot guy.”

Similarly, in Europe, ECB President Christine Lagarde has said the central bank must prevent faster-than-expected wage growth from fueling inflation, and policymakers do appear concerned that high headline inflation rates could translate into higher wage settlements, risking a wage-price spiral. With this in mind, rate cuts appear to remain a distant prospect in Europe, too, and we cannot rule out the possibility that the ECB will lift the deposit rate to as high as 3.5%.

What does it mean for investors?

The recent decline in inflation does support a slower pace of interest rate increases from major central banks and is consistent with a likely “peak” for interest rates in the first half of 2023.

Sustainable rallies have historically required investors to anticipate rate cuts, not just an end to hikes.

However, as we discussed in our Year Ahead outlook, sustainable rallies for the broad equity indexes have historically required investors to start anticipating actual rate cuts, rather than a mere end to hikes. And here, uncertainty is higher. Tight labor markets and continued hawkish commentary mean it is likely to be hard for financial markets to fully anticipate interest rate cuts, and we should therefore expect more volatility in the near term.

Investment views

The near-term backdrop remains one of high inflation, rising rates, and slowing growth. At the same time, lower inflation, China’s reopening, and relatively resilient growth data have been positive for markets over recent weeks. And when inflection points are reached, market rallies can be swift.

We incorporate a combination of defensive, value, and income opportunities, alongside select cyclicals.

We therefore like strategies that provide exposure to equity market upside while adding downside protection. We also think selectivity will be rewarded, and our positioning reflects that. We incorporate a combination of defensive, value, and income opportunities that should outperform in a high-inflation, slowing-growth environment, alongside select cyclicals that should perform well as and when markets start to anticipate the inflections. Diversification, including into alternatives, remains a key pillar of portfolio risk management in the current environment, while we continue to see long-term opportunity in the era of security and by investing sustainably.

This month we make the following changes to our asset class preferences:

• We upgrade emerging market equities from neutral to most preferred. We expect China’s reopening to be positive for export demand, and over the course of the year anticipate a weaker US dollar, which tends to be supportive of emerging market stocks. Earnings momentum and earnings estimate revisions are bottoming relative to developed market peers. The MSCI Emerging Markets index still trades at a 40% discount to MSCI W orld (at a 12-month forward price-to-book ratio of 1.5x versus 2.5x), a level historically consistent with positive performance in the next 12 months.

• We move consumer discretionary stocks from least preferred to neutral. Although slower US growth could continue to weigh on the sector, China’s reopening should provide a boost, particularly for the more traditional, less tech-oriented parts of the sector. Overall valuations have improved over the last 12 months; the sector’s price-to-earnings ratio was trading at 24x at the beginning of 2022 and is now at 18x, or a 5% discount versus the 10-year average.
• We upgrade commodities from neutral to most preferred. Commodities continue to benefit from secular demand drivers, such as the global shift toward net-zero carbon emissions. We now also anticipate a cyclical upswing in demand as economies approach growth inflection points. China’s faster reopening should benefit both energy and industrial metals. The lack of adequate supply growth or even outright production cuts also favor higher prices in energy, industrial metals, and parts of agriculture. Expected returns in commodities benefit from attractive carry; downward-sloping futures curves offer roll gains, while higher yields have improved returns on cash collateral. A risk to our view is that China’s property sector recovers more slowly, reducing the expected pickup in commodity demand.
• We move emerging market bonds from neutral to most preferred. Spreads have tightened recently on the back of the decline in US inflation, the shift in China’s COVID policy stance, and increased support for China’s property sector. Our view is that this can continue over the short term. We see the performance of this segment being driven by carry and upside on special situations in the distressed space. This includes sovereigns willing and able to work with the International Monetary Fund or other international lenders, or where we see upside to potential restructuring scenarios.

• Within fixed income more broadly, rate volatility has moderated as the inflation outlook has cooled and expectations grow that central banks are close to the end of their rate-hiking cycles. All-in yields remain appealing, particularly relative to opportunities in other asset classes, and investor demand for fixed income exposure has increased. We maintain a preference for high grade (HG) and investment grade corporate bonds (IG).
• In corporate high yield (HY), tighter lending standards feed through with a lag, and the current slower growth and earnings in developed economies suggest higher default risk in the future. Additionally, liquidity risk premiums are likely to rise over time as global money supply continues to shrink. As a result, we see corporate HY spreads as being vulnerable relative to corporate IG and HG and have a least preferred stance on HY.
• We move our view on the euro from least preferred to neutral. China’s reopening should be positive for Eurozone exporters, and the ECB is likely to keep monetary policy hawkish for some time to bring down inflation. We have a preference for the Australian dollar, which is supported by China’s reopening, Australia’s relatively strong economic growth, and a central bank that is likely to keep the reins tight when the Fed starts to ease monetary conditions. We change our most preferred view on the Swiss franc to neutral after its strong gains against the US dollar. Nevertheless, we believe the Swiss National Bank is committed to preserving the franc’s strength to limit imported inflation, and that the currency will be supported by safe-haven flows. In the UK, the weak growth outlook and still-high inflation are likely to weigh on sterling, and we maintain our least preferred view.

Visit?our website ?for more UBS CIO investment views.

Please visit?ubs.com/cio-disclaimer ?#shareUBS