December 2022

2023 Investment Outlook

Once again it is time to reflect on the year that has passed and make some predictions for next year. As was the case last year, I won’t attempt to predict a level for equity markets at 2023 year-end but rather I will try and discuss the main factors we see influencing markets as we move into the New Year. I will also suggest some ways to manage around risks that we will likely face as investors. Given the pummelling markets experienced this year, it is natural to hope for something better. While we can’t exactly promise that, we do feel markets are better positioned to withstand continued inflation fighting by global central banks.

It was almost exactly a year ago that the US Federal Reserve (Fed) Chairman, Jerome Powell, announced he no longer felt inflation was transitory (it had reached 7%) and it was time for the Fed to act. Other major central banks would follow suit over the next few months. The Fed surprised markets with their determination and the size and speed of their rate hikes. They raised rates nearly 400 basis points in seven months and not only stopped their $120 billion monthly buying of treasury and mortgage-backed securities but are now actively running down their portfolio by $95 billion a month. This was more than the equity and fixed income markets could handle and both asset classes suffered.

Are we in for more of the same next year? Well yes and no. The Fed probably has a few more rate hikes to do, but we believe they are no longer going at a 75-basis point per meeting pace. Inflation may have peaked, as it has fallen back to 7.7% in October after reaching 9.1% in June. The Fed has suggested they will hike more slowly in the months ahead but acknowledged rates may go a bit higher than capital markets are pricing. This has been a small bit of relief for markets and it has played out in the risk rallies we have seen over the past two months. So further hikes will not seem as shocking as the ones earlier this year. The danger is that financial markets are expecting, and pricing, the Fed to start cutting rates later in 2023. That is going to depend on inflation, and we just can’t be certain it will fall back to the 2% target fast enough to allow the Fed to begin cutting. More likely is that we will have to suffer some very slow or even negative growth in order to bring inflation back down to target (or to a substantially lower level the Fed is comfortable with). So, we may face slow or negative growth with a Fed that isn’t cutting rates. Ouch!

The European Central Bank (ECB) also rose to the occasion and hiked rates (200bps) more than the markets expected taking rates from -0.50% to now 1.50%. Yes, they still had their policy rate negative at the start of this year, which looks crazy in hindsight, and they were still buying bonds as well. Will they get more aggressive and surprise us further? We doubt it, as they are in a much tougher position than the Fed. The Eurozone faces much higher energy costs than the US which hurts households and business by reducing their purchasing power, but these high prices also push inflation higher.

Unfortunately for Europe, it purchases much of its energy from Russia who now, because of the war with Ukraine (which no one predicted), can no longer supply gas and oil to Europe. With the loss (or feared loss) of Russian energy on the world markets energy prices soared and drove inflation sharply higher in the spring and early summer. Fortunately, energy prices have fallen back to roughly where they began the year. This is consistent with what appears to be peaking inflation in Europe as well. Perhaps the ECB will hike another 100 basis points or so next year. Again, not surprising the markets.

The UK has had a similar experience to Europe with European energy prices impacting UK energy prices and inflation racing higher. The Bank of England (BoE) was the first major central bank to hike (back in December 2021) and they have since hiked at eight consecutive meetings bringing rates up to 3%, at the time of writing. Unfortunately, inflation is at 11% and the BoE has never sounded aggressive or even confident that they would be able to tame this.

To make matters worse, the Conservative led UK Government has managed to have three Prime Ministers and four Chancellors this year! Pound sterling plunged to near parity with the US dollar and bond yields rose over 100 basis points in a few days when the second of this year’s PMs (Liz Truss) announced a radical fiscal spending expansion in early autumn. This was quickly reversed by Rishi Sunak (the third Prime Minister of the year) and his new Chancellor of the Exchequer, Jeremy Hunt, who in fact decided to tighten fiscal policy as well. You couldn’t make this stuff up. It is likely the BoE hikes another 100 basis points as well but like the ECB they will be very sensitive to the impact of higher energy bills on consumer and business spending and will also watch the impact of proposed fiscal tightening.

China has, until very recently, been a big disappointment for investors. The government persisted in operating a zero Covid-19 policy that shut down huge swathes of the population and the economy off and on all year. This proved frustrating for international firms who sourced manufacturing in China. The steadily deflating housing market continued to unravel without any strong or organised government response. To make it worse, President Xi Jinping (just reappointed for another 5-year term) focused his attention on deflating and reigning in big tech and tech tycoons in China (has anyone seen Alibaba co-founder Jack Ma?) and expanding and reinforcing the Chinese Communist Party’s control over the economy. The overall result has been poor returns for Chinese equities and a concerted move by western firms to find alternative places to manufacture their products. Note Apple’s recent move of some production of the iPhone to India. More recently, mass protests by the public has led the government to loosen Covid-19 related lock down protocols. This has prompted a sharp rally in many Chinese assets, but it is likely the reopening will be bumpy. The direction of policy change is evident, and we would expect to find some opportunities in the domestic side of the Chinese economy. Exports will still struggle as weakening demand overseas is having a significant impact on Chinese growth.

China has insisted on using their own vaccine which is reported to be only half as effective as the western produced vaccines. Also, many elderly Chinese people have refused to be vaccinated so a widespread reopening will likely lead to a huge surge in cases, which while not fatal will overwhelm the Chinese health system and no doubt require some controls to be reinstated.

Japan has been the odd man out in major central bank activities as they still maintain their negative rates and yield curve control policies. While inflation has now risen to 3% the Bank of Japan insists that this is not high enough and further that the inflation is coming from the wrong sources, that it is prices rising and not wages rising. They continue to buy virtually every 10-year Japanese government bond issued. As a result, the Japanese Yen has weakened dramatically, encouraging Japanese capital to flow overseas to obtain returns and protect purchasing power.

Were Japan to modify this policy and let the market determine the level of interest rates there is no telling how far yields might move (rise). There would also be a sharp retrenchment in capital outflows from Japan which would certainly impact world financial markets. This is a space to watch.

The key factor to recognise for next year is that we have entered a very different world. Interest rates are no longer hovering around zero. Central banks are no longer buying trillions of dollars’ worth of bonds in order to stimulate financial markets and the economy. Cash now has a positive yield that is likely to rise by another 100 basis points or more next year. The valuation of risk assets when cash yields 4-5% is very different from the valuations when cash yields zero. While much of this adjustment has happened (lower stock prices and lower bond prices) there is more to come. Real estate and private markets come to mind as areas where a reckoning will occur. Not to mention crypto where the revaluation is taking place right now. Over the last decade or so, central banks had been dampening volatility in markets - they are no longer doing that. Markets will continue to experience greater volatility than we have seen over the last decade.

Also, for reasons that haven’t been fully identified, there is a clear shortage of labour in most developed economies. It appears most pronounced in the US and the UK. This is causing continued demands for higher wages that are generally being met which keeps upward pressure on inflation. In the UK these demands are now resulting in industrial action in form of strikes, that run the risk of seeing the country grind to a halt. Central banks will be fighting inflation all next year.

Well then what do we do? Firstly, there is nothing wrong with holding a bit more cash or short-dated government securities as you are finally paid something, at least in nominal terms. Secondly, we will want to hold stocks in companies that have pricing power, that are comfortable in an inflationary environment and are businesses that will be able to weather slowing activity. Health care is one example. Value names, of course, come to mind but possibly even some growth names where the P/E valuations have had a large downward adjustment. We also believe that the steady shift towards more sustainable and green energy production is a long-term secular trend. This shift perversely requires a lot of energy use and raw materials that need to be mined. We still like the old energy names and commodity producers. There has not been enough capex spending in this sector, and this is keeping prices firm and should push them higher. China reopening will only add to upward pressure on energy and commodity prices. The reopening will be sloppy, but we expect will find some opportunities there as well. We also will not trade down in quality or liquidity. There will certainly be more casualties revealed because of higher interest rates. Staying conservative is the sensible path.

We very much appreciate your confidence in us and look forward to continuing to do our best for your portfolio.

Jeffrey Brummette

Chief Investment Strategist

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