The world is currently experiencing several significant transformations, including the ongoing information revolution, the green revolution, and the remote working revolution. During transition periods, adaptation becomes necessary, which in turn introduces uncertainty. Presently, the world is facing an increased number of unsettling events compared to usual.
Between a global pandemic, social and political upheaval, the war in Ukraine, the global impact of China’s reopening, a standoff between Republicans and Democrats in the United States over the debt ceiling, and escalating tensions between China and the US, the world’s economy was inevitably going to take a hit. Everyone is searching for investment insights to help them make the most of their money. And we’re happy to offer our own insights on the current investment landscape.
Known Unknowns Vs Unknowable Unknowns
These events are the known unknowns, and there is always the potential for unknown unknowns, which could bring unforeseen challenges. When geopolitical events heavily influence public sentiment, financial markets can fluctuate between risk-on and risk-off modes, making it difficult to rely solely on logical and fundamentals-based investment strategies. However, despite the tendency to focus on potential adverse outcomes, it is crucial to consider the possibilities for positive developments in times of uncertainty. When sentiment is fragile, positive advancements can lead to a sudden surge in market performance.
Amidst elevated inflation and significant increases in interest rates, it is not surprising that economic growth slowed down in 2022. Nor is it surprising that many are now seeking investment insights that will enable them to bounce back during this economic downturn. There has, however, been an unexpected twist in the tale in the form of the resilience shown by many Development Market and Emerging Market economies. The reopening of China, declining commodity prices (especially in the energy sector), and lower-than-anticipated inflation rates in the United States contributed to supporting growth in the last quarter of 2022 and the start of 2023.
And while we started the year with hopes that we’d soon have a clear idea of what to expect and that the threat of recession could be set aside, we still need to determine as we approach the year’s midpoint.
Addressing The Elephant In The Room: Inflation
Although it is undesirable to impede economic growth significantly, central banks may find it necessary to induce a recession to curb inflation. The presence of robust labour markets in the US and Europe has posed a significant obstacle in the quest for a recession. Throughout history, the US has never experienced a recession without exhibiting labour market weakness. A global recession or economic slowdown in 2023 remains a potential risk.
However, it is crucial to recognise that recessions are a natural part of the business cycle, and a temporary deceleration also presents opportunities. It allows for removing weaker companies from the market, enabling more substantial businesses to thrive and resulting in a more rational allocation of capital. Before the conclusion of a recession, stock markets tend to rally as they transition from a pessimistic outlook to factoring in the subsequent recovery.
Balancing Our Outlook For Investment Insights
Recent positive developments must be balanced against the challenges posed by the gradual impact of higher interest rates and inflation rates on the economy. As economist Milton Friedman famously stated, the effects of monetary tightening on the economy have “long and variable lags.” This is because economies are intricate systems with numerous interconnected forces, requiring time for businesses and households to adjust.
Recent evidence suggests these lags have become shorter over time. Increased central bank transparency has made it easier for policymakers to communicate their intentions in advance, allowing markets to anticipate and price these actions. Additionally, economies have become more “financialised,” meaning that the transmission of market movements to the real economy is quicker than it used to be in credit-based systems.
With this uncertain environment in mind, we have made three key investment insights during the first half of 2023…
Investment Insight #1: Concerning Inflation
The inflation outlook is improving, but there is still discomfort about it. Last year, the biggest concern in the market was inflation. However, inflation peaked at the end of 2022 and is decreasing this year. However, there are questions about the extent of this trend and how quickly global inflation will reach levels that central banks find acceptable. As a result, the comfort level for central banks may be higher than their target of 2% annual inflation, which we are likely to reach at the end of 2024.
It is still uncertain what this means for the inflation forecast in 2023. While there have been positive signs of inflation decreasing, there have been some setbacks, such as better-than-expected economic activity and higher prices for services, travel, and leisure. We expect inflationary pressures to subside, but the progress may not be linear. Inflation will likely remain above the US Federal Reserve’s target of 2% throughout the year, but it will be significantly lower than last year. Inflation will also decrease in the UK, but it is expected to be higher than in the US. Although there has been some progress, more work is needed to address the issue of inflation.
A Shift To Economic Growth
There is increased sensitivity to news about global inflation dynamics in the current financial markets, and the focus has shifted to economic growth. The ample liquidity provided by central banks has fueled the rise of risk assets. The recent increase in inflation pressures in Europe has warned against prematurely declaring victory on inflation. This raises the possibility of a hard landing later in the year as the only way to control inflation effectively.
The financial markets experienced significant volatility in the first quarter, with positive economic data from China, Europe, and the US leading to notable shifts in short-term inflation expectations, accurate interest rates, and the US dollar. Bond market volatility has also affected gold, lumber, and energy prices. Moreover, the direction of the global economy in 2023 is likely to be influenced by China, with Europe’s momentum slowing and the US potentially facing a policy-induced recession.
The US dollar has seen a broad rally due to better-than-expected economic data and the unwinding of short positions, particularly against the Japanese Yen and the Australian dollar. The expected appointment of Kazuo Ueda as the new Bank of Japan Governor is likely to maintain stability in future policy decisions. Credit spreads have risen slightly in line with weakness in global equity markets, but low supply and renewed demand for lower volatility equity substitutes have provided some stability. However, with the surge in bond market volatility, investors are expected to remain cautious and take on longer-duration investment-grade credit risk.
An End To Easily Accessible Liquidity
Different sectors and regions performed differently, with cyclical sectors underperforming and technology and industrials outperforming. Growth stocks marginally outperformed value stocks, which is unusual in a weaker market. European equities outperformed US equities, while UK equities showed resilience despite strikes and downbeat economic forecasts. The strength of the US dollar affected emerging markets’ performance.
The era of easily accessible liquidity has ended, and with it, companies that struggle to articulate their profit-generation strategies have faded away. Instead, the focus has shifted towards the robust US labour market, which has outperformed expectations, leading to increased inflation expectations and postponed rate cuts until next year.
Given the prevailing uncertainty, one might assume that it is prudent to avoid riskier investments in the face of questionable economic conditions, inflation, and interest rates. However, market wisdom suggests that the most challenging investment decisions often turn out to be the best. In periods of market certainty, such as late 2021, complacency takes hold and asset valuations become inflated. The current situation is different.
Investment Insight #2: The Goldilocks Scenario
Based on overarching trends, recent market volatility, and the declines in specific asset prices, our assessment aligns with our base case that valuations in many asset markets are fair. At the same time, investor positioning and sentiment remain balanced. It can be described as a Goldilocks scenario, where conditions are neither excessively hot nor cold. Consequently, we opt for a balanced and diversified approach in our investment strategies. While this philosophy is generally adhered to, it holds particular relevance now due to the persisting issues that require further evaluation.
Not all investments are equally valued. For instance, the landscape currently needs to be clarified and contradictory when it comes to equity markets. Valuations range from expensive in the case of the US to cheap when analysing emerging markets. The UK and Europe fall somewhere in between.
Current valuations in US technology sectors are difficult to rationalise, although we acknowledge the sector’s continued importance in the global economy’s development in the coming years. Conversely, we maintain confidence in industries such as healthcare, infrastructure, and renewable energy, which will play equally crucial roles in the decades ahead, and currently offer more appropriate valuations given the uncertain environment.
Surprisingly, fixed-interest markets have become an area of excitement. The global economy and financial markets have undergone significant changes since the last decade, and the turbulent twenties have been marked by extraordinary volatility. The consistent economic growth, low inflation, and interest rates observed in the previous decade, accompanied by high asset market returns, have been replaced by discussions of recessions, persistent inflation, and a comparatively new paradigm for interest rates.
Looking back, we consider 2022 as a necessary and long-awaited event that brought about a much-needed reset for fixed-income markets. It removed us from an unusual situation caused by central banks, characterised by zero interest rates and meagre bond yields. It returned us to the normal state of fixed-interest markets before the financial crisis.
Investment Insight #3 The Once And Future Investment Interest
Opportunities arise for long-term investors due to changes and more rational valuations. Bond yields have been negative for over a decade, and cash interest rates have remained at zero. However, the tide has turned. Although this transition proved painful in 2022, it signifies a return to normality, which can be advantageous. Valuations have become more reasonable after a challenging 2022. While valuations primarily affect long-term returns rather than short-term ones, lower valuations today indicate higher expected returns in the future. Amidst various themes, the common thread is change. Existential risks like wars, climate change, and social transformation introduce uncertainty and create opportunities for investors who can embrace change and leverage its disruptive nature.
Many fixed-interest investments are now once again providing compensation to investors for the various upcoming challenges. The consequences of the banking sector’s impact on credit markets in March resulted in higher yields and lower prices, while spreads (the additional yield obtained from investing in corporate bonds compared to government bonds) have widened. If our base scenario of slow growth, subsiding inflation, and interest rates reaching their peak is accurate, it could create a positive environment for numerous fixed-income investments. Therefore, we maintain a favourable view of specific segments within this asset class.
However, we remain cautious about assuming excessive interest rate risk. As we approach the second half of this year, one of the significant challenges for the markets will be the substantial issuance of government bonds required to fund financially constrained governments amidst declining tax revenues. Consequently, one of the greatest investment insights we can offer is prompting you to question the negative impact this may have on market interest rates, so we can all exercise maximum selectivity in our investment choices. Furthermore, we acknowledge that in a slower economic climate, with limited access to cheap credit due to recent problems some banks face, corporate insolvencies and defaults will likely increase from their shallow levels.
What Does The Future Hold For Investors?
By now, we had hoped to have gained a clearer understanding of the investment landscape and obtained definitive answers to the questions that occupied our thoughts at the end of 2022. We should remember that seeking certainty in financial markets is impossible. And, as Henri Frederic Amiel once eloquently said, “Uncertainty is the refuge of hope.”
Predicting the actual performance of the economy, the possibility of inflation settling, and the actions of central bankers are challenging. Nevertheless, our base scenario of low growth, subsiding inflation, and unchanged interest rates is sensible. Nonetheless, maintaining an open-minded approach will be crucial.
In terms of asset markets, we have more confidence in our perspectives. Numerous appealing investment opportunities within the fixed-interest and equity realms offer attractive future returns. When combined with selected alternative investments, these opportunities instil optimism about the years to come.
We also hope our investment insights have provided some clarity. For help and advise on managing your investments and getting your money working for you, get in touch.