By Kyle Wales
Markets are pricing in a rosier 2023, with inflation rates falling from 2022 – a year of upheaval. However, investors who bet on the future currently informing financial market valuations are unlikely to make money. They need to have a different view, be it positive or negative, and that view needs to pan out.
That won't be easy if there are surprises of the magnitude that disrupted the world economy and financial markets this year. Looking back on 2022, there was Russia’s invasion of Ukraine on February 24 has dominated newspaper headlines ever since. Then there was the overturning of Roe vs Wade, Nancy Pelosi’s visit to Taiwan, the assassination of Shinzo Abe (Japan’s former prime minister), the death of Queen Elizabeth and the circus act which has become de rigeur of British politics. But the thing that has come to define 2022 has to be the return of inflation – the 1970s, 10%-plus type of inflation that we haven’t seen for decades.
And, while inflation was the key feature of 2022, it will also be the key factor determining how markets perform in 2023. Why is this? Should inflation fall faster than the market expects in 2023, there will be fewer interest rate hikes (or maybe even cuts?), and this increases the chance that the world will either avoid a recession completely or that any recession will be short and sharp, as opposed to long and drawn out.
So, where do we stand today? Most indicators point to a steep drop in inflation in 2023. First, US inflation has started to trend downwards. It peaked at 9.1% in June and has fallen each of the last four months to a low of 7.7% in October. Second, many of the factors that have contributed to high inflation have started abating. Chief among these is the oil price, which peaked at US$127 a barrel on August 8 and which, at last print (December 7), was $78 a barrel. Other commodities have also fallen from their highs. The only potential upset to this prevailing downward trend would be the opening up of the Chinese economy, which may lift demand for commodities once again.
The problem with this rosy outlook is that it is largely priced into markets. As an investor, you don’t make money betting on a rosy outlook if that rosy outlook transpires, you only make it by having a different view of the market (whether positive or negative), and that view proves to be correct.
Equity valuations are by no means “cheap”, with the blended forward P/E ratio of the S&P 500 still above its long-run average (17X versus a long-run average of 16X), and there is a substantial risk that 2023’s earnings come in below what the market expects. Blended 12-month forward earnings were still being upgraded as recently as June and have been cut by less than 5% since then.
Here are my expectations for asset class returns in 2023, with the usual caveat that this should not be considered financial advice:
Currencies
I would expect the dollar to remain strong. Interest rates are considerably higher in the US than in other OECD nations, while inflation is lower. Let’s use the Euro as an example. The forecast one-year real (post-inflation) yield is a negative 4.2% in Europe, while it is a positive 1% in the US. Europe would have to hike rates quite aggressively, or inflation there would have to drop considerably for this equation to move in the Euro’s favour. Of course, investor sentiment towards the EU may improve for another reason, although I would not bet upon this happening.
Equities versus bonds
I would be overweight bonds (or its shorter duration equivalent, cash) and underweight equities. Equities are unattractive in the near term (due to the risk of earnings disappointments) and long term (due to valuations). However, pockets of opportunity may be presenting themselves.
Within equities, sectors that sold off considerably in 2022 may also have bottomed. With technology stocks, for example, many commentators attributed their poor relative performance in 2022 due to the magnified impact that a rise in interest rates has when a greater part of their value extends further into the future. Once inflation and interest rates start declining, these stocks may outperform the market. In addition, less defensive sectors that have performed poorly due to fears of a recession may, counter-intuitively, outperform when a recession arrives as the market looks forwards towards a recovery.
Lastly, longer-duration bonds in the US are now starting to offer positive real yields for the first time in a while. The US 10-year nominal bond offers a yield of 3.45%, while the US 10-year breakeven inflation rate is 2.25%1.
Domestic versus global
Domestic stocks and bonds are also priced quite attractively. On the stock front, the South African ALSI P/E ratio relative to the S&P 500 is more than 1 standard deviation below its mean1. On the bond front, the South African 10-year nominal bond offers a yield of 11%, while the SA 10-year breakeven inflation rate is 6.27%1 However, for most South Africans, the decision to invest domestically or globally should be made for diversification reasons because they already have an unbalanced exposure to South Africa rather than purely based on valuations. South African political risk, after all, continues to be substantial.
In making any prediction of what the market might do in the year ahead, one is reminded of how much of what happened in the past year could not have been predicted. Therefore, the most valuable lesson you can draw from an exercise such as this is how important it is to have a longer-term time horizon, as that goes a long way towards removing “luck” or “chance” from the equation. In the end, it pays to take a long-term view, no matter how uncertain or volatile the current market conditions are.
Kyle Wales is a portfolio manager at Flagship Asset Management.