13 Jan Financial markets price in a rosier outlook going into 2023
As published by Business Day on 10 January, 2023
Inflation will remain the key factor in determining performance
2022 was a year of upheaval. First, there was Russia’s invasion of Ukraine on the 24th of February which has dominated newspaper headlines ever since. Then there was the overturning of Roe vs Wade, the visit of Nancy Pelosi to Taiwan, the assassination of Shinzo Abe (Japan’s former prime minister), the death of the Queen Elizabeth and the circus act which has become de rigeur of British politics. But the thing which has come to define 2022 has to be the return of inflation. 1970’s, 10%+ type of inflation that we haven’t seen for decades.
And, while inflation was the key feature of 22, it will also be the key factor which will determine 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 inflation dropping precipitously in 2023. Firstly, (US) inflation has started to trend downwards. It peaked at 9.1% (y-o-y) in June and has fallen in each of the last four months to reach a low 7.7% in October. Secondly, many of the factors which have contributed to high inflation have started abating. Chief among these is the oil price which peaked at USD 127/barrel on the 8th of August and which at last print (7th of December) was USD 78/barrel. Other commodities have also fallen from their highs. The only potential upset on the horizon to the 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 in. As an investor you don’t make money betting on a rosy outlook if a rosy outlook transpires, only by holding a different view to 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 being above is 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 twelve-month forward earnings were still being upgraded as recently in June and have been cut by less than 5% since then.
So, what are my expectations for asset class returns in 2023? (It comes with the usual caveat that this should not be considered financial advice).
I would expect the dollar to remain strong. Interest rates are considerably higher in the US than other OECD nations while inflation is lower. Let’s use the Euro as an example. The forecasted 1 year real (post inflation) yield is negative 4.2% in Europe while it is 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 some other 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. I believe equities are unattractive in the near term (due to risks of earnings disappointments) and in the long-term (due to valuations). However, pockets of opportunity may be presenting themselves. Sectors which sold off considerably in 2022 may also have bottomed. If one takes technology stocks, for example, many commentators attributed their poor relative performance in 2022 to the fact because their cashflow streams extend further into the future so rising rates had a greater impact on their valuations. If inflation (and interest rates) has peaked, there may be only one left for them to go i.e., up. Sectors that have performed poorly due to fears of a recession, may counter-intuitively outperform when a recession arrives because the market may begin looking forward towards a recovery. Lastly, longer duration bonds in the US are now starting to offer positive real yields. The US 10 year nominal bond offers a yield of 3.45% while the US 10 year break even inflation rate is 2.25%1.
Domestic versus global
Domestic stocks and bonds are also priced quite attractively. On the stock front, the P/E ratio of the South African ALSI 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 on the basis of valuations. South African political risk continues to be substantial.
In making any prediction what the market might do in the year ahead, one is reminded by how much of what happened in the past year one could not have predicted. Therefore, the most valuable lesson one can draw from an exercise such as this, may be how important it is to have a longer-term time horizon as that goes a long way in 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.
 Source: Bloomberg.
 Source: JPM, IMF. JPM “Global Data watch” dated 3rd of December 2022 for 1 year forward rate forecasts, IMF “World Economic Forecast” from October 2022 for forward inflation forecasts. USD: risk free rate 4.5%, forecast average inflation 3.5%. Euro risk free rate 2%, forecast avg inflation 6.8%.