This month, we were joined by Hugh Gimber, Global Market Strategist at J.P. Morgan Asset Management and James Ashley, Head of Market Strategy at Goldman Sachs Asset Management. We explored inflation, potential recessions, and the impact of both on company earnings and valuations, before discussing sustainable investing in 2023.
The inflation questions currently plaguing economists are:
How far will it come down?
How quickly will it come down?
And how will central banks respond?
However, it’s also important to bear in mind what inflation will be in the medium term. For this year in particular, there will be two factors at play that should cause it to go lower.
A recessionary backdrop causing demand to be weak, relative to supply.
Energy prices no longer rising at the same rates.
Whilst that won’t mean price levels go back down, reduced rates of inflation will inform policy decisions. Broadly speaking, in the UK, EU and US, inflation will be in the region of 3-4%. This is still uncomfortably high, but for central banks, inflation’s moderation will give them the ability to start behaving differently. That, in turn, will create a backdrop much more favourable for risk appetite.
Additionally, the impact of the labour market cannot be forgotten as an important determinant of how closely inflation gets to its target by the end of this year. There are lots of signs now that economic activity is weakening, but the labour market is the one lasting pillar of strength - whether it's in the EU, the US, or the UK.
Low unemployment rates are leading to very high levels of wage growth. Recent UK labour market data, for instance, pointed to wages rising in the region of 7% year over year. Such a figure is not consistent with the central bank target of 2% inflation. Wages need to moderate the labour markets, which needs to cool to meet inflation’s 2% target by year end.
Inflationary pressures will remain persistent in the longer term, however. These will be fuelled by:
Energy prices: The world is coming towards the end of an era of cheap energy with decarbonisation now on the horizon.
Less cheap labour: There has been a plethora of cheap labour which will be less abundant as the likes of China move up towards middle-income status.
Deglobalisation: Increased frictions in the movements of goods and services have introduced extra costs.
As a result of these pressures, central banks may evaluate whether the 2% inflation target needs to be rethought, particularly if medium-term inflation is stickier and at higher levels than has been seen over the past couple of decades.
Finally, in terms of localised inflation, the UK is likely to see slightly stickier rates than the US or the Eurozone this year, as the UK is dealing with both their inflationary-causing problems. In the US, the labour market is tight with shortages and too strong wage growth while Europe is suffering from high energy prices. So, while the direction of travel for inflation is lower, the Bank of England might be grappling with higher inflation for some time to come.
General consensus across the board sees developed market economies sliding into mild recessions in 2023.
While economists have been historically poor at forecasting recessions (of the 150 recessions seen in 60 countries between the 1990s and 2019, only 5 of them were predicted in advance by a broad group of economists), it looks like for once economists may be right about this one. Even the ECB has claimed that they expect a short mild recession now, whereas only a few months ago they were expecting weak, positive growth. For the UK, the economy may perhaps experience a slightly longer and more painful recession than developed market peers due to weaker growth and higher inflation.
The fact that this developed market recession has been so widely forecast, has its implications. Knowing that it is coming impacts and changes behaviour. Generally speaking, that’s because deeper recessions have followed a period of booming economies with:
Then, with a big shock when an economy weakens, there is a much deeper correction.
This time around, there does not appear to be the big boom which would justify seeing a big bust in the economy to bring it back into balance. So, whilst developed market economies are still quite likely to go into recession, importantly, they are expected to be mild.
That being said, whether we see a mild recession or weak growth, the difference doesn’t hugely impact investors and asset prices. So, even if developed markets do technically go into recession, it’s important to take an objective, holistic view of economic health. When the differences (i.e. 0.1% growth versus 0.1% contraction) are so small, it can be better to frame investment decisions by looking at the depth and length of recessions instead.
Despite the wider acceptance of weaker growth, equity markets may still be forecasting company earnings slightly too strongly. It appears that the focus from an equity market perspective is very much on:
What central banks are doing.
When they are going to drop down the pace of normalisation.
How close we are to the peak.
However, while these questions are key to considering fair value in the market, it’s important to remember the impact of a recession on earnings and the lagged impact of monetary tightening that has already been introduced.
Monetary policy often takes about 18 months to have its maximum impact. Bearing that in mind, there are plenty of headwinds from an earnings perspective, so the growth that has widely been forecast may be a bit too optimistic. However, as the recession is anticipated to be mild, which will only translate into a relatively mild contraction in earnings, there shouldn’t be a decline of 30% to 40% in earnings (from peak to trough) as was seen in the financial crisis.
Whilst there are differences across markets in terms of the bigger picture, from an equity market perspective, it may be better to be a little more cautious for the time being. Even when earnings are projected to grow by about 2% to 3%, that may still be too optimistic.
Bond and equity valuations
A major correction in bond valuations is all but guaranteed, with 2022 being the worst year on record for global bond markets. Overall, fixed-income opportunities look far more attractive than they were 12 months ago, and it is generally quite an exciting place to be.
Looking back just three years ago, a large proportion of Government bonds had negative yields or yields of less than 1%. Building fixed-income portfolios was tricky, but with negative-yielding debt having now disappeared, it’s no longer a hindrance for fixed-income and multi asset investors. Plus, the disappearance of negative yields suggests that the investment backdrop is more normal than what has been seen for the past ten years.
However, it’s crucial to remember one of the reasons why there is a move back to higher, more normal rates: central banks are stepping back from QE and moving towards QT. So, a major reason that yields have been suppressed and valuations have been elevated is no longer there. Investors are now no longer on the same ‘team’ as the Fed, the ECB, or the Bank of England. In some ways, investors will take the opposing position as central banks are selling securities that they have been adding to their balance sheets for the last decade.
Government bonds and investment grade credit now look much more attractively valued, though investors may still be warier of lower quality credit where spreads are still not quite wide enough yet. Targeting corporate credit (and sometimes even high-quality sovereign paper) is a common theme currently among many asset managers. However, as fixed-income investors can no longer ‘ride on the coattails’ of central banks, investing must now for fundamental-based reasons.
On the equity side, valuations broadly look a lot more reasonable across the board, except for the S&P 500. Growth stocks in this index may have come a long way off their exuberant highs that were seen this time last year, but the gap between growth stocks and value stock valuations is still too wide. Investors, who prefer value over growth, will see that multiples in sectors such as energy and financials seem to be much more realistic.
The timing of central banks starting to cut rates is also uncertain in the market. The Fed cutting rates as soon as the second half of this year (as some predict) could be a little premature. It could well be in 2024.
Sustainable investing in 2023
From a climate change perspective, 2022 was difficult. The one asset class that performed last year was commodities. However, from a regulatory perspective plus the simple reality of climate change, investing sustainably will come back to the forefront over the next few years. So, while 2022 was a bad year for sustainable strategies, that will primarily have been with regards to exclusionary strategies which would always do badly in a year where energy stocks were up 30% to 40% versus the benchmark.
Investors will increasingly work closely with management to be active owners to ensure companies adhere to climate transition plans. Renewable energy companies had a bad 2022 as it was a brutal year for all growth stocks. As a result, 2023 could provide the opportunity for some interesting entry points, particularly with more stable bond yields and policy tailwinds, which could potentially only get stronger this year.