December 2022 / GLOBAL MARKET OUTLOOK
The Need for Agility
A time to be selectively contrarian
- Central bank efforts to tame inflation have reached a critical point. In 2023, investors will be looking for the peak in interest rates.
- U.S. earnings growth estimates may be too optimistic. But we see relative valuation advantages in some equity sectors and in non-U.S. markets.
- The worst bond bear market on record pushed yields to some of the most attractive levels since the global financial crisis. Investors appear to have noticed.
- The threat of global economic decoupling has been exaggerated, but big structural changes are in progress. We see opportunities amid the disruptions.
Heading into 2023, capital markets appear to have priced in a significant global economic slowdown. The key question is whether this deceleration will end in a “soft landing”—with slower but still positive growth—or in a full‑fledged recession that drags down earnings.
Much depends on the U.S. Federal Reserve (Fed) and the world’s other major central banks as they continue efforts to bring inflation under control by hiking interest rates and draining liquidity from the markets.
“History is not on our side,” says Sébastien Page, head of Global Multi‑Asset and chief investment officer (CIO). “Fed hiking cycles don’t generally end well, especially when inflation is running high.”
But investors shouldn’t assume a deep downturn is inevitable, Page adds. Although some leading indicators have weakened (Figure 1), U.S. employment was still growing in late 2022. Corporate and household balance sheets appeared strong. And the economic wounds inflicted by the COVID pandemic continued to heal, notes Justin Thomson, head of International Equity and CIO.
Geopolitical risks will remain potential triggers for downside volatility in 2023. Structural factors, such as bank capital requirements that constrain market liquidity, could magnify price movements, both up and down.
With most central banks seeking tighter financial conditions, investors can’t count on them to intervene if markets fall, warns Andrew McCormick, head of Global Fixed Income and CIO.
“We’ve come out of a period where central banks had strong motivation to suppress volatility,” McCormick says. “Now, policy is aimed at tightening financial conditions. So there is no buyer of last resort when markets come unhinged.”
But excessive pessimism and volatility can create value for agile investors, the CIOs note. An attractive point to raise tactical exposure to equities and other risk assets may appear in 2023, Page predicts. However, as of late 2022, it had not yet arrived, in his view.
Until it does, Page favors a “selectively contrarian” approach of tilting toward specific sectors within asset classes—such as small‑cap stocks relative to large‑caps and high yield relative to investment‑grade (IG) bonds.
In difficult markets, security selection will be critical, Page says. “Active management skill is just incredibly important in this environment.”
Leading Indicators of Economic Growth Are Fading
(Fig. 1) Purchasing Managers’ Index Levels for Manufacturing
Explore our four themes:
1. An Economic Balancing Act
Central bank efforts to bring inflation under control have reached a critical point. In 2023, investors will be looking for the peak in interest rates.
2. Leaning Against the Wind
U.S. earnings growth estimates may be too optimistic. But we see relative valuation advantages in some equity sectors and in non-U.S. markets.
3. The Return of Yield
The worst bond bear market on record pushed yields to some of the most attractive levels since the global financial crisis. Investors appear to have noticed.
4. Deglobalization in a Connected World
The threat of global economic decoupling has been exaggerated, but big structural changes are in progress. We see opportunities amid the disruptions.
Entering 2023, investors stand at a major turning point in capital market history. The global economy has passed from decades of declining interest rates into a new regime marked by persistent inflationary pressures and higher rates.
“The era of cheap money, high valuations, and super‑high asset returns driven by multiple expansion is over,” Thomson warns.
Regime change clearly presents risks. But markets may have overreacted to some of those risks in 2022, creating attractive potential opportunities for investors willing to be selectively contrarian:
- Valuations in most global equity markets have improved markedly, although U.S. equities still appear expensive relative to their own history.
- Fixed income yields have reached attractive levels, given what appears to be a manageable outlook for credit downgrades and defaults.
- Structural challenges could boost capital spending on supply chains and renewable energy development, allowing investors to seek the new winners.
In this environment, McCormick says, investors will need to be able to blend top‑down macroeconomic insights with detailed bottom‑up fundamental research. “You’ll have to be able to judge how the big macro changes are likely to filter through the markets.”
Finally, some investors may need to adjust their tolerance for risk, McCormick concludes. “Many of these issues are just very hard to forecast,” he says. “People will have to expect that their portfolios are going to experience volatility.”
It’s Not the Heat, It’s the Illiquidity
The potential for market volatility will only increase as the Fed and other central banks raise rates and press ahead with quantitative tightening, Page warns. “The biggest risk right now is liquidity.”
In 2022, Page notes, bear markets unfolded in two stages. The first was a rate shock as the Fed raised rates from zero to 4% over a nine‑month period. This was followed by a growth shock as investors discounted the risk of an earnings downturn.
In 2023, Page warns, investors could face a third bear market stage: a liquidity shock, in which markets decline across the board as leveraged positions are unwound. While painful, such shocks also can create major buying opportunities, he says.
“A liquidity event could mark the kind of capitulation that typically has marked the bottom of a bear market,” Page says. “Those historically have been very strong buy signals.”
Successfully timing a market bottom is notoriously difficult, Page notes. But history suggests investors don’t need to be precise to benefit from temporarily depressed equity valuations.
According to Page, in 17 previous major U.S. bear markets (defined as a decline of 15% or more in the S&P 500 Index), an investor who shifted just 10% of their portfolio from bonds to stocks near a market bottom could have significantly enhanced portfolio returns over the subsequent 12 months—even if their timing was three months early, three months late, or somewhere in between.1
Investors may want to be more cautious now, however, Page says. Historically, he notes, the chances of successfully investing around a market bottom were significantly lower when inflation was high and interest rates were rising.
That’s one reason to take a selectively contrarian approach in 2023, Page says: The Fed is no longer backstopping investors by limiting market volatility, a policy known as the “Fed put.”
“When there is no Fed put,” he says, “you want to be a bit more patient about leaning in.”
2023 Tactical Views
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