2023 starts cheaper but with new (and old) risks
Happy New Year to all my readers. I have good news. Markets ended 2022 strongly. On a regular basis I track the total return performance of 46 individual indices covering a broad range of equity and fixed income markets. All 46 of them began 2023 at levels above their 2022 lows. Just under half of them are at least 10% higher. The most spectacular rallies from the lows of 2022 have been in Chinese H-shares (those listed in Hong Kong, up 43%) and Asian high yield bonds (26%). Even long duration fixed income assets have rallied despite ongoing increases in central bank interest rates. Long-dated UK gilts (over 10-year maturities) are up 18.3% with the equivalent US Treasury index up 11%. Those assets that have only managed to eke out a modest recovery include German bunds, the NASDAQ index and S&P 500 growth stocks.
So while 2022 was a horrible year in total, many investment portfolios will have been in better shape by 31 December than was the case at the time of last year’s market lows (13 October for the S&P 500, 24 October for the US Treasury Total Return Index). While not wanting to fall for the fallacy of the narrative, the one thing that is probably common to markets rallying in the fourth quarter (Q4) of last year was the peak in concerns about inflation and the subsequent pricing in of a top in the interest rate cycle. That outcome is not guaranteed of course, which poses one of the risks to market returns in the months ahead.
War and rates remain an issue
The two key influences on market sentiment and investor behaviour last year were the war in Ukraine and the aggressive tightening of monetary policy in most major economies. There was - and is - a link between the two of course, as the war triggered an energy shock that quickly fed into higher consumer price inflation. With hindsight, there was a collective under-appreciation of the negative impact of Russia’s invasion of Ukraine on the global economy and financial markets. War is bad news and this one came when the global economy was still recovering from the pandemic. Russian President Vladimir Putin’s actions generated huge political and economic uncertainties: How, when and if the conflict would end or escalate; the impact on the global energy market and consequently growth and inflation; and potentially changing geopolitical alignments. Some of these uncertainties remain and pose another threat to markets in 2023.
But the worst may be done
The initial shock of the war and the bulk of the monetary policy tightening is behind us though. As noted above, market performance has improved as the impact of these events has diminished. It could be that a continued military stalemate in Ukraine and a few more (reduced) incremental changes in policy rates will not themselves be triggers for another leg of the bear market. Indeed, a failing Russian operation and a definitive end to interest rate hikes as inflation falls away could push the investor sentiment ‘swingometer’ further towards optimism.
A global growth slowdown is certainly one part of the outlook, but by now that won’t be a surprise. However, it will be an issue for equity and credit markets if we do start to see weaker macro trends reflected in corporate earnings and balance sheet weakness in the months ahead. Now however, markets are robust, with the US seeing a very strong start to the year in terms of corporate bond issuance. Investors don’t seem overly concerned about credit. I have said for some time that fixed income is much more attractive now we have higher yields, and high-quality credit should provide interesting risk-adjusted returns. Of course, the rally in markets been significant and yields are off their highs. Using the US Treasury 10-year yield as the global benchmark, the 3.5% - 4% range looks set to be in place for a while, potentially providing short-term trading opportunities but also allowing higher yielding credit to deliver decent returns to bond investors.
The severity of the downturn and its geographical distribution will be more important, perhaps for sectors like technology and economies like the UK. The British economy is underperforming. Relative to a base of Q1 2019 and taking current quarterly GDP forecasts to Q2 2024 from the Bloomberg consensus, the UK is the worst-performing G7 economy. There has been a lot of commentary recently arguing that Brexit has led to a significant loss in economic output (recently discussed in both the Financial Times and The Economist). At the same time, the political atmosphere is feral. The public sector is fractured, and the ruling Conservatives are way behind in most opinion polls. Investors need to prepare for a change of government when a general election is held in 2024 (if not before). After rallying in Q4, another leg lower in sterling would not be a surprise.
China is central to many investment themes. My colleague Aidan Yao has pointed out how surprisingly quickly China has shifted from its ‘zero-covid’ policy to reopening the economy and lifting most restrictions. As China opens, the impact on the domestic and global economy could be significant. But it is not as straightforward as saying that GDP growth will be stronger and Chinese markets will do better. In the short term the rapid spread of COVID-19 is likely to be a negative for activity as cases and deaths rise. The experience from other countries is that once the disease has passed through the population, and especially if vaccination levels can become more effective, then economic activity will rise strongly. This should be seen on numerous levels – higher consumption and private sector investment, increased volumes of foreign trade and travel, and a potential recovery in China’s property market. This Sino-recovery might also be an additional source of global inflation at some point.
China and tech
There are ongoing geopolitical risks posed by China as well, given its historical ambitions over Taiwan. That situation is complex as anyone who has read Chip War: The Fight for the World’s Most Critical Technology by Chris Miller would appreciate. To simplify, the global technology sector relies on US-designed micro-chips being fabricated in Taiwan, with many devices then assembled in China. There are numerous choke points in this global supply chain, hence President Joe Biden’s ambition to encourage more fabrication capabilities to be constructed in America. Any intensification of political tensions in East Asia could cause problems for the global technology sector, already hit by a post-pandemic decline in demand. This is likely to be a recurring theme in 2023. Even if the case for investing in tech remains strong from a long-term point of view and tech companies became a lot cheaper in 2022, the sector is likely to remain a source of volatility in equity markets as big players seek to secure more robust supply chains.
Apart from the above-mentioned book, my other holiday read this year was Doom: The Politics of Catastrophe by Niall Ferguson. Not only does he provide fascinating historical parallels to how the world reacted to the COVID-19 pandemic, but also a framework for understanding how disasters – both natural and man-made – are of varying levels of significance depending on whether they were any way predictable, and how they are transmitted through social, economic, and political networks. It got me thinking about crypto-finance and the collapse of the FTX exchange towards the end of last year. I have thought for a while that the crypto-financial infrastructure could pose a threat to mainstream financial markets if there was a liquidity run. So far it hasn’t. Perhaps crypto is just not “networked” enough – the cross-over with mainstream markets and the banking system is maybe not as advanced as thought. As such, a major crypto meltdown might not be as big a risk as say, a rise in high yield bond defaults.
As an aside, I have read a few articles recently arguing that blockchain is perhaps not quite the technological leap forward it was cracked up to be. Developments in artificial intelligence and cloud computing are orders of magnitude more important in terms of their application across economies – in transport systems, construction, healthcare and the energy transition. The current decline in jobs in the technology sector itself potentially provides an enlarged pool of tech experts moving into other sectors providing a source of investment and productivity enhancement.
Land of the rising yield
Sticking with Asia, Japan is also a source of a further shift in the post-QE paradigm. In December, the Bank of Japan allowed bond yields to rise, with the 10-year benchmark government bond yield rising from previously being anchored at 0.25% to 0.5%. Whilst not exactly an aggressive policy change it is important if it marks the first step in a more profound shift in monetary policy (one that could possibly be seen once the current governor’s term in office comes to an end this spring). Japanese government bonds (JGBs) are still way less attractive than other G7 assets from a pure yield point of view but if market interest rates are going to become more determined by market forces rather than Bank of Japan intervention, then there are potential implications for Japanese institutional investment flows. Given current short-term foreign exchange hedging costs and market yields, Japanese investors struggle to get hedged returns in other government bond markets that beat JGBs. For investment grade credit, Europe still offers a modest yield pick when hedged back to yen. But if Japanese yields move higher, Japanese flows might be something of a headwind for US and European high quality bond markets.
What’s in front of you
Markets will develop their own narratives as the year gets underway. Big geopolitical themes will be part of it but so will the ongoing battle between analysts and central bankers over the right level to stop signalling monetary tightening. As always, the data will be key. The question for investors, given the rally in markets since October, is whether to hold back investing cash until there is another (probably inevitable) set-back, or take the view that there is more upside to come as the balance between inflation and growth improves. While individual events won’t fully dictate what happens to asset prices, there are several events that can impact on market sentiment – Q4 corporate earnings to be released in the coming weeks; the impact of Chinese New Year on the progression of COVID-19 and the subsequent opening of the Chinese economy; and whether Putin’s call for a ceasefire in Ukraine is the beginning of the end of the conflict. To borrow a footballing term, you can only invest in what’s in front of you, so assessing value, risk and whether the expected returns meet one’s financial goals, is as important as it ever was.