Monthly Investment Letter: A Year of Inflections

After a year of infections, a year of injections, and a year of inflation, we are about to embark on “A Year of Inflections”—the theme and title of our just-published Year Ahead 2023 publication.

As we head to the end of the year, markets have been rallying on hopes of a policy pivot by the Federal Reserve and an economic “soft landing,” fueled by cash on the sidelines. But with inflation still high, interest rates rising, and economic growth falling, we favor defensives and value, income opportunities, safe-haven currencies, and diversification with alternatives.

Looking further out, inflection points for inflation, interest rates, and growth are all likely in the year ahead—and navigating those turning points will be key to investing success in 2023.

As the year evolves, we think inflationary pressures will recede, central banks will shift from tightening to loosening policy, and economies, currently slowing, will find a trough.

So, investors with the discipline and patience to stay invested in line with longer-term goals should be rewarded. And those currently sheltering from volatility will need to plan when, and how, to head back into riskier assets.

Navigating market volatility

The past couple of months have provided a clear illustration of the kind of dynamics we can expect in the year ahead—with markets torn between grim present realities and hopes of a better future.

Markets have been under pressure amid weaker corporate earnings and fears of tightening monetary policy. But a softer US consumer price inflation report for October drove a significant rally in equities and bonds and a sell-off in the US dollar, as investors looked forward to potential inflection points in the economic data.

Hopes of a reopening in China added fuel to the fire. Yet despite these green shoots of spring, colder weather is coming, and the risks remain elevated:

• First, the Federal Reserve continues to say it will keep raising rates and accepts the risk of overtightening in its effort to vanquish inflation.
• Second, while the data suggests inflation has now peaked, that is not the same as falling smoothly back to target, and tight labor markets mean inflation could still prove sticky.
• Third, corporate earnings still face the lagged and cumulative effects of policy tightening, meaning downward pressure is likely in the months ahead. And fourth, while we do expect an economic reopening in China in the middle of next year and see recent announcements as a validation of that view, the government remains committed to lockdowns as the country tackles winter waves of the virus. That will mean sluggish growth for the world’s second-largest economy.

In this market environment, investors on both sides of the risk appetite spectrum face challenges:

• First, investors sheltering from volatility by holding onto cash could miss out on substantial upside when key turning points are reached. Although we do not think the most recent inflation data is sufficient to drive a sustainable rally, the market reaction so far has shown that rallies around inflection points can be sharp and intense. Investors underexposed in the market today risk missing out on the sustainablerally when it comes.
• Second, more trading-oriented investors could overreact to individual data points and get sucked into what could ultimately prove to be a bear market rally. The sharpness of the recent rallies following improvements in US inflation point to a fear of missing out on year-end gains. But that rally might not prove sustainable if the economic data deteriorates once more.

Rallies around inflection points can be sharp and intense.

Finding a peak: Our outlook for inflation and rates

Historically, markets have found a bottom once investors have started to anticipate Fed rate cuts. Since 1962, on average, the 2-year US Treasury yield—a proxy for interest rate expectations over the next two years—has fallen by 119 basis points in the six months prior to a bear market trough.

Last month’s inflation data did point to a significant slowdown in core inflation, from 0.6% month-over-month in September to 0.3% in October. Real-time indicators of future inflation, including new rents, wage growth, import prices, and price-paid indexes, are also almost all pointing down; durable goods prices are falling; and services inflation is largely being driven by profits—an unusual and likely temporary phenomenon.

The improvement in the inflation outlook is starting to be reflected in Fed expectations implied by the US 2-year Treasury yield, which has fallen around 35bps from its highs.

Greater clarity is needed that inflation has not just peaked but is falling back to target.

But markets are unlikely to price more substantial rate cuts until it is clearer that inflation is falling back to target. Inflation peaking could support a year-end rally, but falling from four-decade highs to 2% in a straight line is unlikely. The risk of the Fed having to do more to get inflation back to the target range makes us maintain a defensive stance going into the new year. Labor markets are still very tight, and inflation could yet prove too durable for the Fed’s liking. What’s more, the ongoing strength in the services sector may keep the labor market and inflation from cooling sufficiently, thereby forcing the Fed to keep hiking rates into a hard-landing recession.

By the end of 2023, we think year-over-year rates of inflation should be low enough for policymakers to refocus their attention on rate cuts. But the path to that point is unlikely to be smooth.

Finding a trough: When will growth reaccelerate?

Aside from coinciding with the anticipation of Fed rate cuts, historically, markets have also tended to trough between three and nine months before economic activity and corporate earnings reach bottom, as investors anticipate a turning point for growth. So, the timing of a turnaround in economic and earnings growth will be a key inflection point for 2023.

Today, the Eurozone and the UK are likely already in contraction given the combined impact of the energy crisis, inflation, and monetary tightening. China’s recovery continues to be delayed by issues relating to COVID-19 and the property market. Higher interest rates, tighter financial conditions, and weakening property and labor markets will have a negative impact on the US in the months ahead.

Downward revisions to company earnings estimates are likely to mean more volatility and pressure on risky assets.

In our base case, we are looking for a 4% earnings contraction in the US, a 10% decline in Europe, and 2% growth in Asia, below consensus expectations of growth of 4%, 3%, and 7%, respectively. Downward revisions to company earnings estimates are likely to mean more volatility and pressure on risky assets over the coming months.

But as we look ahead, in our base case, growth in Europe should start to improve in mid-2023 as the continent’s energy crisis begins to ease after the winter. In China, economic growth should also improve, contingent upon a midyear reopening. In the US, a trough is likely to come later given the current momentum in the economy and the lagged impact of tighter monetary policy. But during the second half, consumption and investment should find some support provided inflation is lower and financial conditions are looser.

Overall, global growth should trough around the middle of the year, even if it remains relatively sluggish until 2024. This suggests that a more constructive environment for risky assets should start to emerge during the year, as markets anticipate potential turning points in economic and earnings growth rates.

Exactly when markets start to price a more favorable growth outlook will depend on how far into the future investors are willing to look, and whether the world can avoid another geopolitical, financial, or epidemiological accident in the meantime.

How to invest?

We enter 2023 with our themes reflecting the uncertainty today. We believe the risk-reward for markets in the next three to six months is unfavorable, and our focus is on defensives, value, income, safety, and diversification. But with the backdrop for riskier assets likely to become more positive as the year evolves, we also need to think about how and when to rotate back into riskier assets.

Once interest rate cuts and a trough in growth and corporate earnings are on the horizon, conditions for a durable turning point will be in place. We would expect to see stronger opportunities in cyclical sectors, notably in Europe; growth stocks, including those highlighted in our longer-term investment themes; riskier credits, including high yield; and selling the US dollar.

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