Our first Asset Allocation Committee Outlook for the year came out barely a month ago, but it feels like an age. The economic and market narrative, particularly around global growth prospects, has changed so much.
While markets were rallying as we entered 2023, the International Monetary Fund was forecasting global growth of just 2.7% for the year, with recession an inevitability in inflation-ravaged Europe and China locked down in a seemingly never-ending battle for “zero-COVID.”
Many investors, ourselves included, braced for the point at which reality would crash into over-optimistic projections for corporate earnings, inflation and policy rates—almost certainly in the first quarter or first half of the year.
There was always the potential for a very different narrative to play out, however, and we dedicated one section of our last Outlook to that possibility.
“Will the earnings-related sell-off come sooner or later?” we asked ourselves.
The top-down market consensus was that the market would quickly price in declining earnings projections, giving us the trough in equities around a midyear trough in growth, setting up the recovery trade for the second half of 2023.
While we assumed growth would be weakening, however, we also noted that inflation was likely to be easing, the dollar weakening and central banks tapering rate hikes—“not an obvious recipe for outright bearishness.”
And then the growth indicators surprised on the upside.
China’s reopening is proceeding faster than many anticipated, and that is showing up in higher global growth forecasts. That, together with a halving of natural gas prices, appears to have saved Europe from the recession that looked baked in 10 weeks ago. Purchasing Managers’ Indices (PMI) have been rising. Japan’s data looks similar.
In the U.S., the Institute for Supply Management’s Non-Manufacturing PMI registered a huge bounce-back into expansion in January, with particularly strong new orders. Virtually every jobs-related data point in the U.S. shows an economy generating labor demand at an astonishing rate. The Federal Reserve Bank of Atlanta’s “GDPNow” model suggests that first-quarter growth might be as high as 2.2% annualized, up from 0.7% just two weeks ago (when the average Wall Street forecast was negative).
Back in December when forecasters were polishing their growth outlooks for 2023, the debate was simple: Were we in for a hard or a soft landing? Now the phrase “no landing” has entered the lexicon. Perhaps growth might continue to chug along at some reasonably positive rate? Maybe that’s justification for the New Year’s market rally?
We don’t believe so. Three weeks ago Joe Amato wrote about a “delayed reckoning” with the impact of tighter monetary policy on growth. We think that reckoning is simply being delayed further, potentially into the latter part of 2023.
A stronger January than December should not come as a surprise, given the diminished China- and energy-related headwinds the global economy now faces. We also know that monetary and fiscal policy acts with long lags—and a year ago policy rates globally were still near zero and money growth was robust. Finally, the unique COVID-era and post-COVID economy has been loaded with shocks and surprises, and they continue.
But that doesn’t change our underlying inflation problem; it may even exacerbate it. In our view, the longer the economy is expanding strongly and generating jobs, the more embedded “sticky” services inflation is likely to become, the higher policy rates will have to go and the longer they will have to stay there. That’s what policymakers keep telling us, and we believe them.
In that scenario, even if corporate earnings hold up better than we expect, it’s difficult to make sense of the rally in some of the assets that Erik Knutzen drew attention to last week—things like bitcoin and nonprofitable tech stocks. The performance of these assets is not about earnings, but about valuations, and therefore real rates.
That brings us to the other observation we made a month ago: In the first half of the year, “the technical backdrop could be supportive to equities.”
We see evidence of that. Short covering and tactical buying of last year’s big losers can explain a lot of what’s been going on in equities. Big inflows into high yield and long-duration investment grade bonds is meeting low new issuance, accounting for much of the spread-tightening we’ve seen.
We therefore think it’s dangerous to read recent market performance as fundamental optimism about the path of inflation, policy rates and economic growth. If anything, the demand for corporate bonds suggests that investors thinking about risky assets on a time horizon any longer than six months are skeptical about equity earnings and valuations.
Value-Conscious and Opportunistic
That is why, in the medium term, we anticipate lower earnings than consensus and see a cap on equity market multiples, leading us to favor income within equities and, in multi-asset portfolios, fixed income over equities.
It’s why we think long-term investors need to be value-conscious and opportunistic when looking for entry points into sectors like public and private fixed income, value and small-cap equities, real assets and commodities, which we believe could benefit from the emerging structural regime of less globalization, lower growth, higher inflation and higher rates.
These are views we outlined five months ago in our long-term Investing at a Crossroads outlook, three months ago in Solving for 2023, and a month ago in our Asset Allocation Committee Outlook. The world may feel like it has changed a lot since then. We think it has changed much less than headline market prices suggest.
In Case You Missed It
- China Consumer Price Index: +2.1% year-over-year in January
- China Producer Price Index: -0.8% year-over-year in January
- University of Michigan Consumer Sentiment: +1.5 to 66.4; one-year inflation expectations +0.3% to 4.2% in February
What to Watch For
- Monday, February 13:
- Japan Q4 GDP (Preliminary)
- Tuesday, February 14:
- Eurozone Q4 GDP (Second Preliminary)
- U.S. Consumer Price Index
- Wednesday, February 15:
- U.S. Retail Sales
- NAHB Housing Market Index
- Thursday, February 16:
- U.S. Building Permits and Housing Starts
- U.S. Producer Price Index