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2022 was one of the most complex and difficult years for global markets since the 2008/09 Financial Crisis. The problem was that markets were facing multiple issues that were interconnected but impacted each individual market in a different way.
The year began with optimism as the western economies emerged from Covid lock downs with individuals and businesses wealthier than before the pandemic started.
There were fears that inflation was rising but at that stage it was believed it was “transitory” and just the pains associated with post lockdown reopening.
It would take a while before realisation set in that something fundamental had changed in the labour market.
A generation of older workers had essentially had a trial retirement during lock down and found they quite liked it.
Across the UK, Europe and North America many experienced workers did not come back to work and neither did immigrant workers. Shortages of key products/services thus became common and 12 months on are only just returning to “normal”, companies therefore bid up prices to get what they could, this was true inflation.
This was further compounded by the Chinese leadership refusing to reopen which further restricted the supply of components. Then we had the “ Black Swan” event of the invasion of Ukraine. This was on such a scale that the West could not ignore it and imposed sanctions which threatened the supply of key raw materials and crucially gas for heating and electricity generation.
This led to huge spikes in commodity prices such as oil, gas, coal as well as minerals such as Nickel as companies and governments out-bid one another to build stockpiles.
Again the result was inflation. This forced the US Central Bank “The Fed” to act and has led to the dramatic and record breaking tightening of monetary policy. All the other central banks, including the Bank of England, became passengers on the Fed’s journey and markets were and remain “hostage” to their actions.
We cannot overstate how significant this move has been, at each meeting the Fed kept “turning the screw” raising their forecast of where they expect interest rates to peak, whilst claiming to be immune to whatever economic pain this causes.
Markets globally fell in value and whilst a rally in the last few months has helped, many indices (even when translated into a weak sterling) are showing significant falls on the year.
Bond markets were just as badly hit as equities, this was particularly the case in the UK. Lower risk Gilts were amongst the worst performers on the year with the FT Conventional Gilt Index falling 25% and Index Linked Gilts by 34%.
The Truss/Kwarteng Budget didn’t help but again the Fed is the main culprit here. Gilts are supposed to be the protective element in Balanced portfolios, in 2022 they were among the most damaging elements. This is only the third time since the Great Depression that both bonds and equities have delivered a negative return over a calendar year.
Short Term Outlook
However, whilst all of this bad news sounds dramatic, it is just part of the normal rhythm of markets and a necessary cost of achieving long term above average returns to fund retirement.
In the short term markets are not predictable, price movements are essentially random, however, over the medium and long terms the patterns of performance do repeat and do follow regular percentage movements and timeframes.
Despite all of the complexity and negative news in 2022, markets are still operating within historic norms and we are 12 months into what is normally, on average, an 18 month period of market difficulty.
There are though grounds for optimism, many indices have completed classic 33% falls and bounced; US inflation is now coming down; the Fed is indicating that it will slow the rate of increase of interest rates, it has reduced M2 Money Supply back to pre-2008 levels; China is reopening; commodity prices including oil have fallen significantly; Europe has high levels of gas in storage and the UK seems to have got through its mortgage rate threatening period of political instability.
2023, especially in the second half, is also when Joe Biden will want the US economy to start growing again ahead of the 2024 Presidential Election.
There is overwhelming pessimism about the economic outlook for 2023 in the media, but as investors we always have to ask ourselves “is it in the price” i.e. have equities and bonds fallen enough to account for all of the probable bad news?
Classically, the historic market roadmap suggests that we may still have a tricky first 6 months ahead of us this year.
Markets have also just had another curveball thrown at them, following China’s reopening in response to public pressure, Covid infections have increased significantly in a mainly unvaccinated population, how this will play out is pure guesswork at this stage.
For the next six months equity market direction will be dependent, as ever, on the three key drivers, Inflation, Interest Rates and Corporate Earnings.
The first is now turning positive for markets, the second is moving from negative to neutral, therefore the direction of company profits are going to be what matters for markets.
Corporate Earnings
Normally, if inflation rises so must interest rates to choke it off, then company profits fall as demand collapses, customers can’t pay, banks foreclose and workers are made redundant.
As unemployment rises, house prices fall and an economy goes into a deep recession. At that point interest rates are then cut and a new cycle starts.
If we are being mechanical then markets have already priced in a recession and thus the next two US corporate quarterly results seasons should be bad.
Yet there is currently little hard evidence that the US economy is in recession.
There is lots of pessimistic media talk and there is the nagging worry that the magnitude of last year’s interest rate increases must have unintended consequences.
However, as the following chart shows there is simply no consensus amongst actual market forecasters that a US recession will happen in 2023.
This chart from the Wall St Journal shows a survey of the top 50 strategists and economists in the US giving their probability of a US recession of any kind during 2023. Whilst the average suggests that there is a 65% probability this has a very low degree of confidence attached to it, as the range is from 20% to 100%.
In a nutshell this is of very limited practical use as any decisions based on this chart would in essence just be a gamble.
Why is this the case, surely as interest rates go up a recession is inevitable? Whilst “is it different this time” is one of the most dangerous questions in investment, it might be justified this time around.
There are fundamentally big differences occurring now. Particularly in the labour market but also in personal and corporate balance sheets.
A “normal” recession comes after period of excess and possibly reckless lending (just as in 2008).
The pandemic meant that consumers and business have record levels of cash and low levels of debt. This is different.
Clearly, this is not across the board of socio economic groups and business sectors, but the majority are wealthier than they ever have been and are not as exposed to the usual risks associated with higher interest rates.
The pandemic also meant that companies slimmed down as much as they could during the initial lock down and thus found themselves short of staff when the reopening occurred far earlier than expected.
Logically therefore these same companies should probably “husband” their staff at all costs, thus unemployment may not rise to the extent that we have seen in the past. If there is no or only a very soft recession then that means that the markets have priced in something that isn’t happening and will have to adjust accordingly.
Furthermore, if one does arrive, then it means that we are towards the end of negative news flow and markets can put an end point on the interest rate moves and start to look through to the recovery.
Either of these scenarios means that we are either very close to end to this down move or will be, in a few months’ time.
Global Earnings and the World Index
(Chart Source: Factset)
As the following chart shows, global markets have pulled back, yet so far earnings haven’t, the question remains will they?
Some sectors such as Retail and Hospitality will inevitably suffer from reduced consumer demand but others including two of the very biggest sectors, Oil and Banks, are finally showing signs of profits growth for the first time in over a decade.
Nevertheless, the consensus earnings forecast for 2023 are for US Corporate Earnings to rise by over 10%.
Even if there isn’t a US recession that does seem to be overly optimistic and out of step with the consensus negative tone.
Analysts are notoriously slow to adjust their forecasts, they rely on guidance from the individual companies and usually the last person to know that a company is being impacted by recession is the Chief Executive!
The background news flow, for a few months at least, may well therefore be negative on company profits.
We should start to see some revised guidance from US companies ahead of the January results season, this should bring this number down to more realistic levels.
This guidance will be crucial for market performance in the first half of 2023.
For long term investors, perversely, it would be better to get the bad news out of the way sooner rather than later. That would also be consistent with historic norms as the following chart shows.
Hard or Soft Landing
(Source: Goldman Sachs)
Here Goldman Sachs has taken the last 12 economic interest rate increasing cycles and separated out the extreme periods of 1974 and the early 80’s.
This clearly shows where we get the 18 month Roadmap period from. Markets fall in response to increasing rates and then start to rise around the last hike in interest rates and keep on going up.
Markets are currently expecting the rate of interest rate increases to slow and pause sometime in the first half of 2023.
This then is also suggestive of a difficult first half of 2023 with growth returning in the second half.
This chart also shows that the valuation, as shown by the Price Earnings ratio at the “Date of last hike” is about 17 times earnings, currently the market is on 19 times, but at the recent low was 17.5 times.
This points to a possible retest of the 3500 level on the S&P 500 at some point before the new cycle can truly get going.
Possibly this is all a bit too perfect, markets rarely do what they are expected to.
However, a contrarian view given all the pessimism would be an optimistic one!
Crucially, the Presidential Election is a fixed date in the calendar, the Democrats need a
boom in the US by Thanksgiving 2023.
The UK Situation
Investment portfolios are driven by Global macroeconomic events and not by domestic ones, however, many commentators have singled out the UK for criticism and are being very negative about the outlook. Often this is a function of too many economists being based in London, but is it justified this time?
Fundamentally yes, it is down to the government’s decision to suck money out of the economy through tax increases whilst interest rates are rising and there is an energy crisis, which makes little economic sense.
It could be argued that this was self-inflicted by the Truss/Kwarteng Budget, but actually started with the big National Insurance increase under Johnson/Sunak.
The more recent increases from Hunt could be best described as a scatter-gun response to a Gilt market crisis. This leaves consumers facing higher energy bills, higher mortgage costs and higher taxes all at the same time.
Furthermore, there is seemingly no strategy to stimulate growth. The Truss growth strategy was way too much way too soon, but at least it was a strategy.
The other key political aspect of the abandonment of many of the Truss plans was that they included much of the “Hard Brexit” policy changes that were promoted to bring about a “Singapore on Thames”.
If these policy changes are now no longer acceptable to the markets then what comes next?
There is still no deal with the EU on Services or Financial Services and the Northern Ireland protocol remains under discussion. Could a return to the Schengen zone be being considered? There has been talk of a Swiss style deal, but the Swiss remain in discussions with the EU themselves.
This is a politically toxic area, but a deal(s) could provide the boost to growth that is needed. The mistakes of the George Osbourne period are being made all over again.
The one benefit is that the inevitable increase in mortgage rates will be minimised, mortgage rates should stabilise around the 4% level, historically still a very cheap level. The other key variable will be energy prices, here wholesale gas prices are falling.
Investment Markets in 2023
Bonds: The fall in global bonds in response to rising interest rates seems to have run its course. Yields are well above expected future inflation rates and are starting to offer good value.
High Yield and Junk bonds are however at risk of defaults if the recession does come and is far worse than is currently priced in.
UK Equities: The FTSE100 has held up well helped by Oil and Mining stocks, thus it is very susceptible to events in the Ukraine and Russia.
The higher growth FT Mid250 was amongst the hardest hit markets and has completed a classic 33% drawdown. This index is more domestically orientated and includes the big Housebuilders, buyers are starting to bottom fish in anticipation of the future recovery.
Overseas Equities: Tech had a bad year as money flowed into Oil and Banks. Despite high valuations and component supply difficulties these companies are very cash rich, if growth does slow and bonds rise in value then Tech will follow.
For Oil it is about Chinese demand and the war in Ukraine. For the Banks interest rates need to hold around this level, a cut would be good for the markets but not for the banks.
Property: Following rule changes Property funds are becoming less attractive despite the underlying assets remaining in demand. Weak sterling is bringing in overseas buyers for West End London, whilst renewable energy projects are very much in demand as well. Property is the last sector to fall and thus also the last pick up.
Far East and Emerging Markets: Here it’s all about China, which in turn is all about the political step backwards away from capitalism and Covid. Just how damaging will this latest outbreak be in a largely unvaccinated population?
Overall: The next few months will be critical for markets, will corporate earning collapse over the next quarter?
In theory they should and perversely many will hope that they do. Why? It’s because it brings the end of this cyclical down move into sight and thus the beginning of another period of growth. The “goldilocks scenario” would be falling US inflation and corporate earnings holding up, that is not priced in by the markets. If investors are patient, the recovery should come in the second half of the year but might just arrive earlier, it all depends on the data.
January 2023
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This information is not intended to be personal financial advice and is for general information only. Past performance is not a reliable indicator of future results.
