31 Jan 2023
We are clearly now in a new macroeconomic regime. The era of low inflation, low interest rates and low macroeconomic volatility is over, for now at least. Recent comments including likely upgrades to economic forecasts by the IMF only reinforce this view. In this new regime, interest rates will naturally fluctuate, but they will not return to zero or ultra-low levels. Tighter monetary policy (higher short-term interest rates) is not temporary, and the easy monetary era is over. All risk assets valuations will need to adjust to account for structurally higher cash rates. In other words, they will need to offer sufficiently high-risk premia over short-term interest rates to be attractive. Listed (stock market quoted) asset classes have adjusted to a significant extent, but many unlisted valuations have yet to reflect this new reality.
A structurally higher level of interest rates and greater macroeconomic volatility will place a valuation constraint on equities in terms of justifiable PE ratios and on bonds in terms of the level of 10-year yields. This is likely to make meeting the required returns by investors through market moves alone (beta) much harder to achieve. As a result, investors need to place a greater emphasis on generating additional returns from active management known as alpha generation. This is difficult to source with confidence, but more volatile macro conditions can produce greater dispersion, in return producing more alpha opportunities. It might be best for investors to focus on less efficient markets as they have historically represented an opportunity for active managers to outperform.
This increased emphasis on alpha generation needs to be quite granular, encompassing regional and sector allocation in equities, duration and credit exposure in bonds, and currency pairs management as well as inter asset class allocation. If macroeconomic volatility is higher, there may be a need to manage these positions more dynamically and in 2023, there remains a range of possible macroeconomic and geopolitical outcomes, none of which can be predicted with any high degree of certainty.
In terms of economic outcomes, what happens in the US will, as always, be a major influence on markets globally. There remain three potential outcomes: a soft landing, a hard landing or stagflation in some form. Under the first of these, the Fed has already done nearly enough in terms of rate rises, giving scope for interest rates to be cut by the end of 2023, with only a mild economic contraction and inflation falling to 2%. Under a hard landing, the Fed will need to continue to tighten policy to ensure enough economic weakness occurs to lower demand, especially in the employment market, reducing upward pressure on wages to return to a sustainable 2% inflation rate which remains its published target. Under a stagflationary scenario (the exact definition of this varies), the Fed initially pauses rate rises and as economic activity weakens, eases policy in the belief that the economy is returning to its 2% inflation target, but when inflation proves sticky and starts to rebound later this year or early 2024, renewed monetary tightening is required. This depicts what occurred in the 1970s and much of the 1980s.
Investor expectations will oscillate between these outcomes. In the earlier part of 2023, economic releases are likely to support the soft-landing scenario; the inflation rate will continue to decline, driven initially by the collapse in goods prices and later, by the fall in the US housing component of CPI. Economic activity will also moderate. This scenario has favourable implications for interest rates. The market is likely to front run this and has already seen a rally on the expectation that the Fed will end its tightening soon, which will ease concerns over a prolonged recession or downturn. However, the Fed cannot afford to ease prematurely. J. Powell, in his May Fed press conference and subsequent Q&A session, seemed to emphasise this point when he talked of his admiration for Paul Volcker and Powell is unlikely to want to repeat the mistakes of the 1970s and become the next Arthur Burns. An early ‘pivot’ remains unlikely, rates are likely to stay at high (restrictive) levels, and during the middle part of the year, fears of a recession could become a more dominant influence.
There is every possibility that by year end the narrative will have changed again and, once the Fed does change course, expectations of an economic recovery will take hold and markets, if following the pattern of recent years, are likely to latch onto this at a much earlier stage than has occurred in previous economic cycles. Early monetary easing would be welcomed by the markets but the third possible outcome, stagflation, would become more likely if the Fed, through political pressure in the face of rising unemployment and weaker economic activity, cut rates while inflation was still above target levels. A pickup in inflation forcing the Fed to reverse tack once again would be viewed poorly by markets. From a timing perspective, the greater risk of this politically influenced outcome is probably not this year, but in 2024 - a Presidential Election year.
Geopolitical events will continue to be an important market influence. An end to the Russia/Ukraine war, or at least a cessation of hostilities remains possible and this would have a positive impact on sentiment generally, especially for European markets, commodities and energy. New Covid-19 variants are continuing to appear and need to be watched closely and the possibility of a mutation to a more virulent form cannot be entirely ruled out.
There are three other key macro developments that need to be reflected in portfolio positioning. China’s relaxing of Covid-19 restrictions, easing of property restrictions and more relaxed attitude to technology are a big deal, not just for China’s growth, but for emerging markets more broadly and commodity demand. China’s growth rebound had global implications in 2009 and this may well be the case in 2023. The US$ has peaked and is now in a downtrend which is likely to be further reinforced by a change in the Bank of Japan’s yield curve control policy post the retirement of BOJ Chief Kuroda in April which will encourage further capital flows to Japan, causing the Yen to strengthen.
Views differ greatly among leading strategists in terms of how economies and markets will perform in 2023. In fact, the range of outcomes by respected market commentators have probably never been wider. Overall, the consensus view entering 2023 was for equities to be weaker in the first half of the year followed by a stronger performance in the second half. The dangers of following a strong consensus were never better demonstrated than in 2023 and this consensus view is different to the pattern suggested above, where initially the early months of the year might turn out to be stronger with a likely upgrading of economic forecasts as a time of falling headline inflation rates, meaning the line of least resistance for the stock market may be up.
For many institutional investors, the pain trade today is for stronger equities. Once the easy gains in inflation have taken place, primarily through lower goods prices and easing supply chain bottlenecks, investors may focus on whether inflation will fall back to central bank target rates, resulting in another period of equity market weakness. By year end there is likely to be sufficient clarity on what central bank policy will be, the level of peak rates, the length and extent of a downturn with a rebasing of earnings estimates and early investor anticipation of the next economic upswing. Within this, the regime shift that has occurred - the move to structurally higher interest rates than have prevailed in the post GFC period - means that markets will continue to trade at lower valuation levels than the past decade so earnings growth will need to reach new highs. Without significant rate cuts, the scope for meaningful capital gains in government bonds would appear muted. The eventual driver of markets to new highs will need to be earnings growth rather than multiple expansion as higher interest rates will keep a lid on market valuations.
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