Monthly Investment Letter: Inflections diverge

Greetings! As we gather here again for our monthly investment letter, I can’t help but wonder…what’s the deal with ChatGPT? Is it a financial genius disguised as a chatbot, or just a digital Magic Eight ball that sometimes gives us accurate predictions purely by chance? The jury’s still out on that one, folks. All we know for sure is that it has a knack for generating some interesting responses and occasionally dropping some humorous quips.*

Of course, ChatGPT is not the only recent development on which the jury is still out. More pressing for investors is that recent US economic data seem to have simultaneously increased the risk of a “hard landing” as well as the chance of a “soft landing” for the US economy.

Headline retail sales, job growth, and services sentiment point to an economy holding up well against interest rate headwinds. But equally, the marginal decline in US inflation in January and a still-tight labor market suggest that the Federal Reserve will need to increase rates further, perhaps substantially, in order to bring inflation back to target.

Caught between these divergent potential outcomes, equity markets have been left trading well above October’s lows while also lacking the conviction to move materially higher.

What is the outlook from here? In our Year Ahead 2023, we said that this would be a year of inflections, in which economic growth would first slow before reaccelerating around the middle of the year. At a global level, we think this view remains intact, but the latest data suggest it is happening at different times in different regions.

• After a period of weak growth over the winter, China’s and Europe’s economies are inflecting sooner than expected, thanks to an end to zero-COVID policies and a significant drop in energy prices, respectively. By contrast, the resilience of the US economy is perhaps raising the risk of a later, deeper recession there, resulting in a more prolonged period of uncertainty.
• For investors, such divergent inflection points increase the risk of misreading market and economic signals. This makes a systematic, holistic, and professional approach to portfolio management particularly important in reducing the likelihood of making strategic portfolio errors.
• Tactically, we think the current environment means investors should ensure they diversify beyond the US and growth stocks. Inflation and interest rate uncertainty means we continue to believe value stocks will outperform growth stocks. And faster inflection points in Europe and China affirm our view that emerging market equities, as well as select parts of the European market, including Germany, will perform better than US equities. Considering the downside risks to the US economy, we also continue to advocate maintaining some defensive exposure, although among defensive sectors we now see greater opportunity in consumer staples than in healthcare.
• Elsewhere, given elevated yields, we continue to see a variety of opportunities across the fixed income spectrum, including in high grade, investment grade, and emerging market bonds. However, we remain cautious on high yield corporate credit. We expect broad commodity indexes to move higher given constrained supply and strong demand. We also continue to believe uncorrelated hedge fund strategies can play an important role in portfolios as we navigate correlated markets still driven by expectations for central bank policy.

US outlook: Fatter tails

The US economy has remained more robust than expected so far this year. More than half a million net new jobs were created in January, and the unemployment rate fell to its lowest level in 53 years. Retail sales rose 3% compared to December, one of the biggest monthly increases of the past 20 years. The service sector also unexpectedly rebounded: The ISM services index rose to 55.2 in January after dipping below 50 the previous month.

The question investors are now grappling with is whether this represents good news or bad news.

Of course, in itself, better-than-expected growth is a good thing, and resilience against higher interest rates could suggest a higher chance of the US economy achieving a soft landing, in which inflation falls back to target and growth remains positive.

But equally, a stronger economy and a resilient labor market could also suggest the Fed may have to raise rates a lot further to cool inflation. The annual rate of consumer price inflation declined only modestly to 6.4% in January from 6.5% in December, and the Cleveland Fed’s trimmed mean, a gauge that strips out the biggest price moves, was up 0.6% on the month.

In our base case, we expect the moderation in inflation to resume. Prices of certain goods that were in high demand during the pandemic, such as used cars and trucks, continue to ease amid a broader shift in consumer spending from goods back toward services. The contribution of shelter to inflation should recede as the calculation of owners’ equivalent rent catches up with last year’s weakness in the housing market. Growing pressure on corporate margins should also weigh on the pace of wage growth.

A robust US economy coupled with above-target inflation will likely increase the Fed’s conviction to keep hiking rates.

Yet the combination of a solid economy and above-target inflation is also likely to increase the Fed’s conviction to continue hiking rates to, or beyond, the point that would push the economy into recession. Markets have repriced their expectations for the terminal federal funds rate. Futures markets now point to a peak rate of 5.3% in August, up from 4.8% three weeks ago. The composition of the Fed’s rate-setting committee may also become more hawkish following the recent appointment of the dovish Lael Brainard as head of the National Economic Council.

Where does this leave us?

First, better-than-expected economic data helped support US equities at the start of the year, but the S&P 500 now trades on a 12-month forward price-to-earnings (P/E) ratio a little below 18x, a level usually associated with environments in which corporate earnings are growing rather than contracting, and the Fed is easing rather than tightening. Yet it is hard to envisage a near-term setup in which profits are growing and the Fed is cutting rates, particularly given that lower corporate margins are one of the key paths to a soft landing.

Reflecting the stronger near-term economic data, we have raised our end-June 2023 S&P 500 target to 3,900 (from 3,700), but we also downgrade our end-December 2023 target to 3,800 (from 4,000), reflecting the risk of higher rates and of recession later in the year. We think investors should diversify beyond the US, including into the emerging markets and Germany.

Second, we continue to see risks to growth stocks. Tech, the largest growth sector, is likely to be hampered by a further slowdown in earnings growth due to a weaker enterprise outlook and slowing consumer demand, while valuations are demanding.

The US dollar may appreciate further in the near term, but we still think it will weaken over a multiyear time horizon.

Finally, we are entering a period of uncertainty in currency markets. As markets consider the data and reassess the probability of much higher rates or a hard landing for the US economy, the dollar may appreciate in the near term. But at the same time, the dollar is still overvalued, and we continue to believe that over a multiyear time horizon, the US currency will weaken against the euro, British pound, and various emerging market currencies. As such, while strength is possible in the near term, investors with a longer-term horizon should use the current USD rally to unwind some dollars.

Europe and China: Inflecting faster

As we entered the year, growth in Europe was challenged by record-high gas prices, and in China by zero-COVID policies. But a sharp fall in energy prices in response to lower demand and an end to zero-COVID policies mean that growth in both regions is picking up sooner than expected.

We expect the Eurozone economy to avoid a recession this winter, although activity is likely to remain subdued. We recently upgraded our 2023 GDP growth forecast to 0.8%, from 0.2% previously. High inflation, an overhang of last year’s spikes in energy prices, and rising food costs will continue to weigh on real income growth in the coming months. However, lower energy prices, falling inflation, and China’s reopening should allow for a modest recovery thereafter.

We expect China’s GDP to grow by 5% this year, led by a recovery in consumption.

Meanwhile, China’s smoother-than-expected reopening already lifted the manufacturing and services PMI data into expansionary territory in January, while mobility data over the Lunar New Year holiday showed an encouraging recovery in travel and consumption. We expect China’s GDP to grow by 5% this year, up from 3% last year, led by a recovery in consumption.

Should we worry about the US debt ceiling?

On 19 January, the United States reached its statutory debt ceiling, leading the Department of the Treasury to initiate “extraordinary measures” to continue to fund government spending.

These extraordinary measures should allow the federal government to pay its operating expenses and debt obligations until at least the end of the second quarter of this calendar year. Unless the debt ceiling is raised thereafter, the US will default on its obligations, with potentially grave consequences for global markets and economies.

Yet, perhaps conditioned by the various collisions with the debt ceiling in the past decade that did not lead to either a US default or any material disruption in market functioning, markets have so far largely ignored the debate around the US debt ceiling. Are they right?

In our base case, we expect Congress to reach a compromise regarding the debt ceiling and avert a default on Treasury securities. Lawmakers still have a considerable amount of time to resolve policy differences, and most of them understand the economic and market peril of not raising the ceiling while long-term solutions to the escalating deficit are identified.

There are risks of course, which could create volatility. A quick solution does not appear likely as Republican lawmakers push for spending cuts in exchange for an agreement on the debt ceiling. At present the Republicans are not pressing for cuts to entitlement spending, which would be highly contentious, but the prospect of prolonged uncertainty remains. During the 2011 debt ceiling standoff, the Treasury was prepared to prioritize sovereign debt service over other budget items to avoid a default, although an agreement was reached before this was required. However, the uncertainty ahead of that agreement led one rating agency to downgrade its US sovereign debt rating. A default remains a possibility this year, albeit remote.

But combative political rhetoric is nothing new in Washington, and the media’s attention to the issue may, counterintuitively, be a positive development, as it may force members of Congress to be more cognizant of the adverse ramifications of a failure to reach an agreement.

How do we invest?

We continue to expect 2023 to be a year of inflections for inflation, monetary policy, and economic growth. But developments over the past month have reinforced our view that inflection points are unlikely to be reached in unison. Investors will therefore need to take a more regionally selective approach to risk decisions, rather than make blanket “risk-on” or “risk-off” calls.

We advocate a more regionally selective approach to risk decisions, rather than making blanket “risk-on” or “risk-off” calls.

Our positioning reflects this, and incorporates select relative value opportunities that should enable investors to position for inflections across the global markets, while reducing downside risks.

First, we expect emerging markets and early cyclical equity markets, such as Germany, to perform better than US equities. We expect China’s reopening to spur domestic consumption, which should benefit China’s neighbors in North and Southeast Asia as well as several commodity-sensitive emerging economies such as those in the Middle East, Africa, and Latin America. Earnings momentum and estimate revisions in emerging markets have bottomed both in absolute terms and in relation to developed markets. Valuations look appealing even after the recent rally. On a price-to-book (P/B) basis, the MSCI Emerging Markets index is trading at a 43% discount to developed markets (12-month forward P/B at 1.5x versus 2.4x for MSCI World), a level historically consistent with a relative positive return over the medium term.

In Germany, the gas crisis has eased significantly compared to six months ago, economic momentum is improving, and China’s better growth outlook bodes well for German exporters. Investor sentiment has started to improve but has scope to recover further, and German equities have still underperformed the Eurozone by 17% since their 2020 high. Valuations are relatively attractive: MSCI Germany is trading at 11.7x forward P/E, an 11% discount to MSCI EMU ex-Germany, which is larger than usual.

By contrast, the US equity market remains expensive in absolute and relative terms. The MSCI US index is trading at a little below 18x P/E, a 12% premium to its 20-year average (16x) and a 17% premium to the global benchmark, the MSCI All Country World Index (ACWI). The robust US economy and labor market have reduced recession probabilities in the near term, supporting this year’s S&P 500 rebound. But as the Fed’s tightening makes its way to the real economy, we expect earnings growth to contract in 2023. Companies are facing a challenging combination of weakening demand, rising labor costs, and unfavorable comparisons with 2021–22 earnings.

Second, we prefer value stocks to growth stocks. The MSCI ACWI Growth Index has outperformed its value equivalent so far this year. But we think an environment of stubborn inflation and higher interest rates should support value stocks’ renewed outperformance in the months ahead. Meanwhile, we expect a further slowdown in tech sector earnings to be a headwind for growth stocks. Sector valuations are also demanding: The MSCI World IT index is trading on a 12-month forward P/E of 22.5x, 20% above its 10-year average. Based solely on the recent relationship with real yields, the IT subindex should trade at a multiple of between 16x and 18x, in our view.

Third, we continue to see opportunity in select defensive sectors, given the risks to the US economy, but we are revising our sector views. We continue to like global consumer staples, which tend to outperform the overall market when leading indicators, such as the ISM index, weaken. Relative earnings momentum is positive and strengthening. While valuations are not cheap, they are in line with historical averages. The sector is trading at 18.9x forward earnings, slightly below the 10-year average of 19.2x.

But this month, we shift our view on the global healthcare sector from most preferred to least preferred. Last year’s stronger US dollar benefited non-US healthcare companies, which generate a high proportion of sales in the US, but that tailwind could become a headwind this year. And, after strong sector relative performance last year and recent earnings downgrades, valuations are less attractive. The sector trades at 18x forward earnings, a 15% premium to the market, above the historical average premium of 7%.

Fourth, in fixed income, we prefer investment grade bonds, high grade bonds, and emerging market bonds, relative to US high yield bonds. All-in yields look appealing across most of the higher-quality fixed income spectrum, and we think favoring higher-quality credit makes sense given the risks to the US economy. We see corporate high yield credit as more vulnerable. 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 the global money supply continues to shrink.

Finally, we favor exposure to broad commodities, which are a good hedge against the risk of more persistent inflation, as well as beneficiaries of China’s reopening. Expected returns in commodities benefit from attractive carry; downward-sloping futures curves offer roll gains, while higher yields have improved returns on cash collateral.

* This paragraph was derived from ChatGPT’s response to my instruction to “write me a witty introduction to my monthly investment letter referencing ChatGPT and uncertainty about what to make of it,” with only minor edits. ChatGPT still has only limited knowledge of the world and events after 2021, so the remainder of the letter is necessarily the product of a living and breathing author.

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