The period since equity markets and Treasurys retreated in March 2022 has been marked by a combination of gloom and confusion, with plenty of talk about a looming recession triggered by Fed rate hikes, but resilient economic data generating a strange air of disbelief.
This is being reflected in commentary from the real economy. On Friday December 9 Bank of America CEO Brian Moynihan told CNBC "American consumers are spending more this year than they did last year. In fact, in the first week of December, it picked up a little bit from November to a little higher percentage say 6% versus 5%. But it’s still strong and it’s consistent with a 2% plus growth economy."
The jury is still out on the likely duration and depth of an anticipated growth slowdown, and how it will impact monetary policy. From our perspective the lack of clarity is the result of the long, fading, tail of post-Covid recovery, and stimulus-buoyed savings accounts, rather than anything to become contrarian about.
The data is unequivocal that a slowdown is coming, with inflation still elevated, earnings revised lower and lower, freight rates collapsing, and even the crude oil price has stalled below $80 a barrel despite ongoing geopolitical tension.
Isn’t this already priced-in to equities? We don’t think so. The October and November 2022 rally was based on divining dovish signals from clear Fed guidance that policy rates will continue to be raised, and a downward correction in the dollar. That isn’t a foundation for a sustained equity uptrend so we expect the market to test its 2022 lows in 2023.
It's always darkest before the dawn
Another leg down in equity markets when the recession actually manifests itself, and the Fed’s terminal policy rate is confirmed, will be difficult for the real economy. This is the time though when investors must act and rebuild growth-oriented equity positions, particularly if, as many expect, the recession is mild in the US. In addition, the Fed’s tough talk through this tightening cycle will face its ultimate test when recession arrives. If the Fed pivots with inflation well above its 2% target, which is possible, that will be a strong signal to get out of cash and back into financial assets whether they be bonds or equities. In that scenario a 2020-like melt-up in equity markets cannot be ruled out.
Figure 1: US CPI still a long way from 2%
Source: S&P Dow Jones Indices, Robeco
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Furthermore, even if the Fed holds its nerve, there are other obvious catalysts that could manifest in 2023. First, if the recession is mild – the fabled soft landing – and earnings projections stabilize, equity investors will conclude the bottom is already in and rebuild positions accordingly.
Second, any ceasefire, or more improbably a peace deal, in the Russia-Ukraine conflict would simultaneously reduce inflationary pressure, release pressure on central bankers and buoy risk appetite. This rosy scenario appears highly unlikely now, but so did war in late 2021.
Third, China’s recovery from Covid is likely to crank into gear after its recent relaxation of pandemic restrictions. Even for China skeptics the impact of a simultaneous recovery in domestic consumption, infrastructure investment and property market stabilization will have a dramatic effect on growth, especially in Asia Pacific.
EM fundamentals are stronger than in previous cycles
The China factor one of the key reasons why we are more constructive on EM than DM. While EM equity returns have disappointed in the past decade relative to the US, fundamentals in Asia-Pacific, Latin America and even Africa are stronger now than in 2008/2009, and the next decade is unlikely to mirror the last.
As we enter what is expected to be a difficult, recessionary 2023 for the US and Europe, that improvement in fundamentals and partial decoupling in monetary policy is likely to see EM enjoy relative outperformance even as the global economy slows down.
The second catalyst we see for EM is a peaking dollar index which combined with the belated recovery in Chinese activity will see EM growth outstrip DM.
What does this mean for positioning? Not a great deal in reality. While we believe EM are better placed, these markets will still suffer from a global slowdown and China’s pace of recovery will not echo the frenzied growth of the pre-Covid era. It does mean though that that flight to safety into the dollar has already played out, and that now is not the time to retreat from or underweight EM.
For our global equity portfolios this is influencing our relative allocations in DM and EM companies and we believe in terms of capital preservation and front-running a global economic recovery, a judicious allocation to high quality EM equities will pay off in 2023.