Back to the future?

2022 has come to an end. For investors and their “famous” 60/40 portfolios (60% equities, 40% fixed income), it will surely remain one of the most destructive years of past decades. Without any doubt, they are looking forward to the reset that a new year represents performance-wise.

KOMMENTAR DES FONDS
17 Jan 2023

2022 has come to an end. For investors and their “famous” 60/40 portfolios (60% equities, 40% fixed income), it will surely remain one of the most destructive years of past decades. Without any doubt, they are looking forward to the reset that a new year represents performance-wise.

Before looking ahead to 2023, let’s consider a few key figures that sum up 2022:

  • 9.1%: US inflation a 40-year high record.
  • 3.4%: US unemployment rate a historical low this time.
  • 284: The number of rate hikes done by central banks in 2022 including 6 for the Fed.
  • -13%: The performance of a US 10 Yr bond – the largest annual decline on record.
  • 20%: The spread between the performance of MSCI World Value and MSCI World Growth.

To continue this list, we can add a few observations: Commodities are the best asset class for the second year in a row even though – against all odds – oil price (WTI reference) ends the year little changed from early January 2022 ($80 per barrel vs. $77). Let’s turn our gaze to more distant geographical zones: The Hong Kong market has hit its lowest level since 2009 while the Turkish equity market has made its strongest progress, up more than 190% in one year and in local currency. So many records, so many excesses at times…

On the Western markets, the common thread linking most of these astonishing records is inflation. Deemed too low for many years and then transitory from the end of 2021 onwards, it is now haunting central bankers’ dreams. CPI and PPI data are eagerly awaited and dictate the performance of equity markets. We can be certain that this will continue until central bankers affirm the path of controlled inflation. Given this, what positioning should the investor adopt?

Since the Summer of 2022, we have taken on a more constructive attitude with regard to fixed-income markets, especially for USD investment grade bonds, the best signatures. We believe that the carry is attractive enough to offset uncertainties surrounding the Fed’s pivot level.

However, on equities, we remain in a split situation, highlighted by consensus figures for 2023. Rarely has the consensus been so focused on the “zero” figure: 0.3% expected economic growth in 2023 in the US, -0.1% expected growth in the Euro Zone, and a meagre 3%: this figure works for earnings growth on both sides of the Atlantic.

In short, the markets are expecting a very mild recession that will only moderately impact corporate earnings. This is obviously less ambitious than the typical forecasts usually released by analysts, but if we adhere to the recessionary scenario, we may also fear that the impact on corporate earnings could be more significant. The markets are “cautious” without trading on capitulation levels. For us, this is an incentive to remain fairly neutral in equities at least for now.

One observation remains encouraging, however: Years such as 2022 in which both equities and bonds fall concomitantly are quite rare. There have only been 13 occurrences in the past 150 years!*. In the year that followed, bonds fell in only two out of 13 cases and equities in three out of 13 cases… In these periods of limited visibility, such favourable figures are a comfort to keep in mind when the time will come to increase our equity exposure in the coming months.

* Source: Les Cahiers Verts de l’Eco.

Macro Focus: 2023, a bad macro vintage expected but not a surprise in itself!

Still robust growth and higher inflation in 2022

As we finished the year, several conclusions can be drawn. Economic growth, albeit robust, decelerated more sharply than expected and inflation proved higher and more sticky than initially feared. After the outstanding rebound in economic growth in 2021, which followed the equally spectacular collapse during the COVID pandemic, some form of deceleration was expected due to less favourable base effects and with the normalisation of monetary and fiscal supports, most notably in the United States.

However, it proved more pronounced as inflationary pressures resulted in tighter monetary conditions. China, which used to be the world’s growth driver also disappointed with less than a 3.5% increase in its GDP – excluding the COVID pandemic – its worst year over the past decades.

It must be said that its economy was largely undermined by both a major real estate crisis and the repeated lockdowns that plagued the country’s major economic hubs. Although cut in half compared to 2021, global economic growth proved nonetheless quite robust with regions like the Eurozone growing surprisingly quite clearly above their potential.

Graph 1: US total and construction industry unemployment rates (left scale) vs. housing starts (inverted right scale)

Graph 1: US total and construction industry unemployment rates (left scale) vs. housing starts (inverted right scale)

Source: Bloomberg, Banque Eric Sturdza.

Secondly, while inflationary pressures had already begun to materialise as a result of the synchronised rebound in post-COVID demand, massive injections of liquidity and bottlenecks created by the supply chains’ disruptions, have increased sharply in 2022 as a result of the Russian-Ukrainian conflict and amplified tensions on commodity markets resulting from it.

If the components linked to commodities were the first to rise, inflation in services and the “shelter” component took over in the US in a context where, despite the economic slowdown, the labour market remains surprisingly strong, but should catch up with the slowing economic activity in the construction and real estate sectors (graph 1: unemployment rates vs housing starts).

What can we expect on the growth and inflation front?

On the economic front, unfortunately not much… Economic growth is expected to stay at around zero both in the US and the Eurozone. In this context, the recession risk remains substantial in the Eurozone due to the induced effects of the energy crisis, a little less so in the US where the slowdown reflects the “hawkish” actions of the Fed.

It should be noted that the recession risk seems to be on the roadmap of many investors and should be less of a surprise in 2023. With the announced gradual end of zero-COVID policies, growth in China and, by extension, in Asia, should reset and accelerate, a feature that the Chinese authorities could accompany with additional fiscal and monetary stimuli – quite at odds with the situation in other developed economies. This is certainly a good reason for hope in 2023, but for that investors will have to be a bit patient and wait for herd immunity to build in China.

With a continued economic slowdown in the Western world, the other reason to be less pessimistic could be the pursuit of disinflation started a few months ago. For that to happen, it would require a not-too-strong and rapid Chinese recovery to avoid experiencing a sharp rebound in commodity prices, whose recent decline has served as the main catalyst for disinflation. While the economic slowdown and overcoming base effects should help disinflation to continue, the price level where inflation will end up remains largely unknown and the central bankers’ 2% target should well remain out of reach in 2023.

The year 2023 could therefore be defined as a mirror image of 2022: zero or almost zero growth in the Eurozone and the United States, with pronounced recession risks, China that will reaccelerate and inflation that should be less of an issue even if it might not go back to its pre-crisis COVID level.

If the macro picture remains pretty bleak, the performance of financial markets could turn out to be less catastrophic, as investors’ expectations are quite different and portfolios’ adjustments have been carried out in 2022. Once again, the external factor – as an example increased tensions between China and the United States, Taiwan, a ceasefire in the Russian/Ukrainian conflict, etc. – could once again play the role of a wild card and require a readiness to adapt to changing market conditions.

Fixed Income: The year 2023 began on the 20th of October

Employment does not weaken, neither does the Fed

The employment figures published at the beginning of December were, once again, impressively robust with 263,000 new jobs created. The stable unemployment rate of 3.7% will allow the Fed to continue its monetary tightening policy. Of course, the pace may slow slightly, but the long-awaited pause is certainly not coming soon.

Fears of a full-blown recession, which are still very high in the eurozone, are diminishing in the United States, and many experts now see a scenario halfway between a soft landing and a “mild recession”. Inflation is down slightly; the PCE Deflator, which is particularly scrutinised by the Fed, has decreased from 6.3% (revised) to 5.5%, while the PCE Core has fallen, as expected, from 5.2% to 4.7%.

The decline is slow and disappointing after such a large monetary tightening marked by four consecutive 75bp rate hikes. Robust employment and still too-high inflation will therefore encourage the Fed to maintain a more hawkish policy than the markets expect. Beware of the post-holiday hangover.

Too early or too late

The long-awaited rebound in fixed-income markets began in earnest on October 20, reaching levels that were still unhoped for in early September. Credit spreads and sovereign rates are now at less attractive levels.

Fixed income markets went a little too fast and a little too far and if we really need to increase our credit and duration exposure in our portfolios, the timing is probably less opportune. We should have done it before the 20th of October or else wait for a correction in early 2023. At the end of 2022, it seems urgent to do nothing despite a last (timid) rebound in rates, triggered by two events.

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The BoJ’s decision to suddenly widen the band for JGB bonds in its Yield Curve Control policy caused Japanese long rates to rally sharply, dragging German rates into the correction.

First, the very hawkish tone of Christine Lagarde at the last ECB meeting caught the markets off guard. Secondly, the decision of the Japanese central bank (BoJ) to suddenly widen the band for JGB government bonds in its Yield Curve Control policy caused Japanese long rates to rally sharply, dragging German and US rates into their correction (but not enough to make them attractive again).

2023, the year of the bond markets?

Theoretically, fixed-income markets are poised for a (potentially spectacular) upturn in 2023. This long-awaited rebound will depend on four elements:

  • The closing levels are on December 31, 2022.
  • The pace of inflation’s decline.
  • The rise of recession fears, and then of the recession itself.
  • The risk of monetary policy errors by central banks (ECB and Fed to a lesser extent).

Finally, it is the evolution of real interest rates that should be monitored above all else, as it is not only the performance of fixed-income markets but also of all other markets, that this will depend upon.

Equity: Health, happiness and success for the equity investor!

As the year draws to a close, we anticipate that 2023 will continue to be a volatile year with a continued slowdown in the global economy. Selectivity and diversification will remain key to navigating this uncertain economic and geopolitical environment.

Some companies are already positioning themselves for tougher times ahead, most notably in the industrial sector. Higher energy costs, especially in Europe, as well as growing labour costs (in the US), are putting a dent in margins, especially in the energy-intensive sectors (chemicals, plastics, metal processing, etc.). Not all companies will be able to pass on rising costs through an increase in their pricing and there will be a strong struggle to hold onto market share both nationally and internationally.

While the recession risk remains particularly high and its scope, potential duration and possible implications are still uncertain at this stage, there is still a breath of optimism, driven by consumer demand that remains robust overall and reassuring energy provisions, whether in terms of energy savings or active storage policies. European governments have been sufficiently responsive since the beginning of the summer to significantly reduce the risk of shortages, at least for this winter and as we are helped by relatively mild temperatures.

As for inflation, it seems to have reached its peak or at least a temporary one. The year 2023 should be more conciliatory in terms of price increases, even if certain measures have a delaying effect, such as the temporary cap on electricity prices in various European countries, which should disappear in the first quarter of 2023. Services are not spared and companies are also bracing for difficulties linked to the rise in interest rates, such as the real estate market.

As for Swiss companies, they have to deal with a strong franc that could negatively impact their exports next year if it remains at such a high level against the euro. This could weaken some companies and make them less competitive internationally despite their leading position and high quality. Stock prices seem to already discount somewhat these effects and Swiss quality companies seem more interesting and attractive today from a valuation standpoint.

In China, the “zero-COVID” policy is progressively abandoned but with some consequences as at the time of writing, the number of contaminations is skyrocketing and could once again delay China’s reopening and recovery. This drastic increase in COVID cases also worries in Europe, which fears the negative side effects on health systems as the Chinese government has just announced the end of the mandatory quarantine upon arrival in Mainland China.

We remain convinced that China will remain a major growth driver and the lifting of some restrictive measures reinforces this view and our positioning, beyond the current upsurge in COVID cases and temporary disruptions caused by that.

Graph 2: S&P500 P/E Ratio (RHS) EPS (LHS)

Graph 2: S&P500 P/E Ratio (RHS) EPS (LHS)

Source: Bloomberg, Banque Eric Sturdza.

Graph 3: STOXX Europe 600 P/E Ratio (RHS) EPS (LHS)

Graph 3: STOXX Europe 600 P/E Ratio (RHS) EPS (LHS)

Source: Bloomberg, Banque Eric Sturdza.

China’s savings rate has risen sharply over the past three years due to the successive lockdowns and the decreased ability to consume, nor the willingness to do it in a depressed environment. This is a positive and important factor.

Indeed, household consumption should become a significant driver of Chinese growth as soon as the economy fully reopens and consumer confidence is restored, as we have experienced “revenge shopping” episodes in Western countries after the pandemic.

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We remain convinced that China will be a major growth driver and the lifting of some restrictive measures reinforces this view and our positioning, beyond the current upsurge in COVID cases.

Japan also represents a great investment opportunity, given its undervaluation and its economic dynamics, which are at odds with the rest of the world. Japan, which shares many specificities and industrial leadership with Germany, could also benefit from the temporary disruptions affecting some of the latter.

While waiting for a clarification of the economic scenario and/or a reset of profit expectations (see graphs 2 and 3: PE ratio vs. EPS), investors are currently being paid with an attractive carry on IG bonds, including EUR ones, and can “wait” before redeploying to equities. In this complex environment, Long Short equity strategies and asymmetric investment solutions have already demonstrated their added value in 2022 and should remain crucial in the way equity portfolios are built in 2023.

When navigating in this complex environment, we remain cautious about equities, as evidenced by our recent hedging of a portion of our US equity exposure. While the risk of recession remains high in Europe, company valuations seem to better discount the complicated situation European corporates are facing and appear in this sense more “de-risked” than the US ones.

However, earnings expectations for 2023 still seem too optimistic and do not sufficiently take into account this recession risk… This is a good reason to remain cautious at the beginning of the year.

Contributors: Edouard Bouhyer (CAIA – CIO, Banque Eric Sturdza), Marc Craquelin (Senior Advisor, Banque Eric Sturdza), Jérémy Dutoit (Heady of Advisory, Banque Eric Sturdza), Pascal Perrone (Senior Portfolio Manager) and Eric Vanraes (Head of Fixed Income).

The original PDF document: „Back to the Future?“ by Banque Eric Sturdza can be downloaded here.

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolios.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 06/01/2023 and are based on internal research and modelling. Please click on BES Disclaimer to view Banque Eric Sturdza’s disclaimers. Please click on Disclaimer Page to view full disclaimers.