2022 was an unprecedented year for markets, with both bonds and equities recording substantial losses at the same time. UK government bonds ended the year down close to 25%, a disastrous performance for a supposedly low-risk asset.
Meanwhile, global equities lost some 15%, although the pain for UK investors was considerably less. A sizeable fall in the pound, particularly against the dollar, meant the decline in sterling terms was reduced. Furthermore, despite the dire domestic economic news, UK stocks were the best-performing major market last year.
The number one cause of the market turmoil was the surge in inflation to multi-decade highs. This prompted central banks to raise interest rates aggressively, fuelling expectations of a slide into recession. This year, inflation should once again be the key factor determining the market outlook.
In the last couple of months, inflation has started to fall back from highs of 9% in the US and 10-11% in the Eurozone and UK. The recent retreat in energy prices, along with an easing in supply shortages and the dropping out of last year’s sharp price rises from the annual comparison, should almost certainly drive further declines in headline inflation rates over the coming months.
However, much more important is to what extent underlying inflation pressures will also subside. If inflation is to return to the 2% level targeted by central banks, wage growth will have to slow significantly from its current elevated levels. The question is how deep an economic downturn central bankers will need and/or be willing to tolerate in order to engineer such a slowdown in inflation.
Interest rates look certain to be raised further over the coming months, most likely peaking in the spring at around 5% in the US, 4-4.5% in the UK and 3-3.5% in the Eurozone. If, as we expect, inflation falls back considerably but remains significantly above target over the coming year, central bankers will not be in a hurry to start easing policy, and rate cuts may have to wait until 2024.
While the Western economies look set to fall into recession due to the cost-of-living crisis and monetary tightening, the downturn should generally be relatively mild. A few structural imbalances led to the contraction in the global financial crisis being as severe as it was.
China should also be an important support. Although the rapid relaxation of the zero covid policy will undermine activity near term, it should fuel a marked rebound by the spring as the economy fully reopens for the first time since the pandemic.
So where does this all leave the outlook for markets? Following the sharp rise in interest rates and bond yields, fixed income is now considerably better placed than it has been for years. Bonds still face some headwinds over the next few months, with rates unlikely to peak until the spring. But after that, prospective returns on government and corporate bonds should be a respectable 4-5% per annum.
As for equities, valuations have fallen considerably and now look much more reasonable. Global equities trade on a 12-month forward price-earnings ratio of 14.6x, some 25% below the peak of 20x seen two years ago and 8% below the long-term average.
That said, equities do now face greater competition from bonds, and now the latter is yielding substantially more. Corporate earnings expectations have also yet to be revised down significantly and pose a downside risk to markets as the slide into recession will take its toll on profits.
Global equities are up close to 10% from their October low. They could well come under some renewed downward pressure over the coming months as central banks tighten policy further and economies fall into recession. By the summer, there should be a much firmer basis for a sustained recovery, as interest rates should have peaked, and investors will be focusing on the forthcoming economic upturn.
US equities have underperformed other markets significantly in recent months, hit by the tech sector’s woes and a fall in the dollar. This underperformance has further to run over the coming year as US equity valuations are still as much as 40% higher than for the rest of the world, and the dollar also remains overvalued.
Instead, we continue to favour Asia and other emerging markets as well as the UK. Asia, led by China and India, should drive a pick-up in the global economy later this year, while Latin America should be supported by continued strength in commodity prices.
As for the UK, its extreme cheapness and tilt to the commodity sectors should stand it in good stead despite the relatively poor domestic economic outlook, just as it has done this past year. Its price-earnings ratio is currently 10.4x, over 30% lower than for global equities and 25% below the long-term average.
All said and done, 2023 looks set to be a considerably better year for markets than the year just passed. That said, all forecasts should be treated with a healthy scepticism given the scale of the forecasting misses over the last year by even the great and the good.
While our investment portfolios are tilted towards those areas which we believe will fare best, they remain well diversified. At SVN Capital, diversification remains the best form of protection, particularly in times of heightened uncertainty. Get in touch with us to find out more.