When the clock strikes midnight on 31 December, we will be celebrating the coming of a new year, but not necessarily a new financial environment. Because the new year is sure to be filled with old concerns when it comes to the investment world.
Although the world is adapting to the effects of the war in Ukraine, it is still hanging over the market. Meanwhile, energy demand will depend on something as unpredictable as how severe the weather in the US and northern Europe will be. And while we are edging closer to the end of US Federal Reserve’s tightening policy, it will not be a quick return to normal. Some analysts may be expecting rate cuts in 2023, such a pivot is unlikely to happen until at least 2024 in our view. We saw only yesterday that whilst the US inflation numbers were softer than expected on Tuesday, Jerome Powell then talked hawkish in his press conference post the announcement of the expected 0.5% hike in interest rates. They seem perhaps inclined to err on the side of overtightening that risking not doing enough to quell inflation. Of course, there is always the possibility that the Fed are merely talking tough so markets don’t get too carried away too quickly given how they have reacted each time there has been even a sniff of a slightly less hawkish tone. Trying to second guess the thoughts of a Central Banker seems a fruitless and thankless task these days!
Much of the economic data, in the US, UK and Europe, are pointing to a downturn. The question we are wrestling with is how deep the recession will be. However, let’s not forget that not all recessions are the same shade of what we saw in 2008. There is a chance that we could see a shallower recession, particularly in the US where the consumer remains in fairly good health – so long as the Fed aren’t inclined to hike until something breaks of course.
With all the strike action in the UK and the country’s specific set of issues, including questions over the credibility of the Bank of England governor, the risks are higher, with inflation looking slightly more structural.
The next earnings season is going to be crucial because the forecast in the US is still buoyant, which means there is room for disappointment if the recession turns out to be deeper. There is a big question mark right now on what the guidance from companies will be in the first quarter of 2023, which will give us a very clear understanding of the shape and the longevity of recession in the US. In our view, it will be a very volatile earnings season.
As we believe there is a high probability for company earnings to disappoint, investors need to be focused on quality businesses with resilient earnings, and companies that are likely to survive a recession and even come out on the other side gaining market share from weaker competitors. Within fixed income, we think that inflation will remain higher than expected, around 4% on average. We are using this as the hurdle for entry into fixed income assets, searching for yield in corporate bonds above 4% on a three-year annualised view.
We admit that we may be slightly too cautious in our view but when there are so many uncertainties going into the new year, it feels right.
With such lack of clarity and visibility, it’s important to stay relatively neutral, which in our case means using our risk budget fully but being aggressive in taking profits on big ‘risk on days’, because there is a possibility that markets shoot up if inflation comes down quite quickly. After the year that we’ve had, we will want to participate in any potential relief rally. That is why we have been building up some cash in our portfolios by taking profits in the recent equities rally and in gilts as well. We want to make sure we have liquidity.
So, 2023 will be a challenge but we are close to the end of Fed tightening, probably past peak inflation and with more realism reflected in valuations (not bargain basement) there is room for cautious optimism. The key is to participate in a recovery as investors won’t be pleased if they miss out.