House View: January 2023

Forecast errors

Economic forecasting often resembles an art rather than a ‘hard science’, considering the multitude of factors entering any econometric forecasting model, the interdependency of the specific factors, and the potential for exogeneous shocks which can thwart the results of even the finest-calibrated model. This year again, economists worldwide have been taught their lesson, and especially those working for the Federal Reserve, supporting the FOMC members in formulating their economic projections. Just 12 months ago, it was expected that the Federal Funds rate will be at 0.9% by the end of 2022 and that PCE inflation will be at 2.6%. As of today, the latter stands at 6.0%, while the Fed’s lead interest rates amount to 4.5%.

The latest set of “SEP” (the summary of economic projections) were published in mid-December. PCE inflation is expected to fall to 3.1% over the coming 12 months, while the Fed Funds rate is projected to stand at 5.1% in end-2023. In our view, these projections are to be read as signals by the FOMC members rather than as any conviction. Translation: the FOMC will remain hawkish throughout next year, while it sees base effects and other reasons providing the setting for steeply falling inflation rates.

Recession or no recession?

Considering the pace of interest rate hikes – today’s 4.5% stood at 0% in mid-March of last year– their effects on the different parts of the economy are only slowly coming to the fore. These headwinds are meeting one major tailwind for the economy: the consumer sector, as household excess savings according to Fed economists stay at more than USD 1.5tn. Together with healthy wage gains as a result of the apparently abundant supply of jobs, a deep recession appears unlikely. However, some milder form of economic contraction as the result of the monetary tightening will be hard to avoid, we fear.

US CONSUMERS’ EXCESS SAVINGS

Source: Bloomberg

We remain convinced that the economic prospects for 2023 have not been discounted in the community of analysts’ and strategists’ earnings estimates. At the beginning of 2022, these estimated that 2023 earnings will be 10% higher than in 2022, now this figure stands at +4%. Taking into consideration the risk of recession, this seems odd, as equity earnings tended to drop 30% on average in the past 50 years’ recession phases. In today’s inflationary environment, rising input costs such as raw materials, energy and wages are a distinct threat to profitability – hence downgrades in earnings estimates will come in 2023. This in turn has a negative impact on earnings-based valuation measures such as the price-to-earnings ratio which have come back from the record levels of 2021, but are far from reaching historical lows that coincided with good entry levels.

In the press conference following the FOMC decision in mid-December, FOMC Chair Powell emphasized the risks to price stability stemming from wage rises that have become the rule rather than the exception. The job labor is still „out of balance“, he said, mentioning the still high job vacancies as well as robust job gains. In the latest Philly Fed Survey, there was mention of companies‘ new stance of keeping employees on the payroll as a result of the difficulties to find qualified staff in the past quarters. The Atlanta Fed Wage Growth Tracker remains at very high levels and has not shown any signs of reversal. Therefore, we do not count ourselves into the camp of those predicting inflation to swiftly return to 2%, but rather stay elevated for several years, as we expect labor‘s share of gdp to grow at the expense of corporate profits.

FED WAGE GROWTH TRACKER AND CPI

Source: Bloomberg

Another pivot

The Chinese leadership‘s decision to rashly pivot away from its zero-Covid strategy has surprised many observers. Whether it was driven by the growing protests against the government strategy of locking up whole cities or whether the Chinese leadership accepted the virus having become endemic, is impossible to say. The consequences of such a pivot – at the beginning of the cold season, complicated by the lunar new year in later January (the major travel period in China) – will be enormous, in our view, with an infection wave rolling over the whole country in the coming weeks. Chances are that the short-term economic effects will be very negative, with a significant part of the population suffering from symptoms, aggravated by a low vaccination rate among the elderly, the most vulnerable cohort of the omicron variant. Put differently, those in the West that had denied the gravity of Covid-related illness may now follow in real-time what would have happened in 2020 and early 2021, if the lockdowns and mask wearing rules had not been implemented.

We take the view that global investors have not fully discounted the prospect of an important economy undergoing a period of public health crisis with potentially stark repercussions for the rest of the world, as China remains an exporting country of highest importance. Already major western countries such as the US and in Europe have seen restrictions on Chinese visitors reinstated. We see the risk for a short-term hit to both equity and commodity markets, should economic activity in China display a temporary breakdown due to an overwhelming wave of covid infections. The plain fact that the number of intensive care unit beds per 100‘000 inhabitants in China is about a tenth of the respective figure in the US, is very concerning. The great advantage that one-party-state China had over the West, i.e. a central decision driving the response to a dangerous epidemic, now appears to be turning into a major disadvantage. The narrative of a political system superior to the Western democratic approach, as was used by the Chinese leadership since the very first days of the pandemic, is now being turned on its head, depending on the degree of devastations to public health in the coming weeks and months.

CHINA GDP GROWTH (YEAR-ON-YEAR)

Source: Bloomberg

Stocks v bonds

2022 has been a very negative year for both stocks and bonds, signified by the fact that a 60/40 stock/bond portfolio had the worst year-to-date return since the mid-1930s. Has the time now arrived to re-enter the bond markets? Considering the current economic environment with the threat of an impending recession, corporate bonds could well experience a further widening of credit spreads, which in the case of high yield bonds likely will amount to another 300 basis points (3.00%) move, weighing on prices. Based on our expectations of inflation to remain much stickier than what current market expectations reflect, we also fear that we have not reached the end of the flagpole in terms of Treasury yields.

GLOBAL HIGH YIELD: YIELD AND SPREAD OVER TREASURIES

Source: Bloomberg

Based on the past 60 years of data, there have been three periods of roughly 20 years if one looks at the difference between nominal GDP growth and Treasury bond yields: the time from the early 1960s to the late 1970s, signified by a high nominal GDP growth rate relative to 10-year bond yields (line in the chart in positive territory). Then came the Volcker-era interest rate hikes, resulting in much higher bond yields while inflation started to come down, bringing the difference of the two into deeply negative territory. Only in the late 1990s did this spread move back into the positive area and oscillated for several years around the zero line. Since 2003 nominal growth was always higher than the 10-year Treasury yield, with the exception of 2007-09, during the Global Financial Crisis (when growth collapsed more than bond yields), and a short period in 2020 when the economy contracted due to Covid.

To us, today’s inflationary environment is not solely the consequence of supply line disruptions in a pandemic context, but the result of by far too low yields relative to nominal growth rates. Exogeneous factors over the past three decades such as the integration of low-cost labor in many emerging markets into the global production processes have kept their lid on price pressures, thus masking the buildup in inflationary pressures stemming from the ultra-loose monetary policy.

US NOMINAL GDP GROWTH RATE – 10-YEAR TREASURY YIELD

Source: Bloomberg

Therefore, we do not expect to see bond yields returning to the low levels of the past decade, but rather a prolonged phase of rising yields until the dragon of inflation lays slain. To bring things into perspective: according to the Fed’s summary of economic projections published in December, core PCE inflation is expected to drop to 3.5% in December 2023 from 4.8% this year (December figure to be published in mid-January – the market is expecting 5.6%). Without taking into account the wide scope for error (which we would see clearly tilted to higher rates of inflation), current 10-year yields of 3.8% seem too low compared to nominal GDP growth of 4%, as the FOMC only sees a meagre real GDP growth rate next year, especially considering central bankers’ intention that “the inflation genie needs to get back into the bottle”.

Tighter financial conditions to come

Another angle from which to look at the prospects of financial markets in 2023 is the level of financial conditions: will they get tighter or loosen again? To us, the outlook is clear, not only due to Mr Powell’s hawkish message, but by drawing parallels to the last time when inflation hit the high single-digit levels. We deem a further tightening inevitable, as real (core inflation-adjusted) rates are still way below the zero level. Even based on the Fed’s own forecast, real rates will only reach 1.6% in end-2023 and, coincidentally, end-2024. This level compares to a level of 3% in 2007 before the Great Financial Crisis and to 4% just before the dotcom bubble started to burst in 2000. In the 1980s, real rates reached more than 10.5% in 1981 and more than 6.5% in 1984. All will be different this time? We think not.

FINANCIAL CONDITIONS AND REAL FED FUNDS RATE

Source: Bloomberg

Another difficult year ahead

The long-famous “Fed put”, i.e. whenever equity markets tanked, the Fed came to the rescue with rate cuts and/or quantitative easing and thus helped lift stock prices again, now has turned into a “Fed call”. Translated this means that whenever equity markets are getting too optimistic about the economic prospects (and consequentially are rising), hawkish talk by FOMC members pushes down markets – as Fed Chair Powell did in mid-December, after the US equity market had risen more than 13% from the lows in mid-October. Subsequently, stocks sold off 5% within a mere week.

We see various reasons for pessimism, when it comes to the financial market outlook for 2023, as stated above. Therefore, we would still hold a considerable amount of liquidity in order to profit from lower entry levels to come. Maybe 2023 will already be the year to enter long duration bonds, however it may take a longer period until the inflationary pressures have left the system, so we remain skeptical on this issue. Commodities will remain sought after, we are convinced, especially in the energy and industrial metals space – and any Covid-surge in China-related drop should be considered an opportunity to add. Precious metals may, after a disappointing 2022, outperform, as renewed investor interest should drive demand in 2023, though not only private investors, but global central banks which bought 400 tons in Q3 of 2022 alone – signifying the need for some autocracies (the biggest reported central bank gold bullion buyers were Turkey, Uzbekistan and Qatar) to diversify “away from the USD”. The freezing of some USD 300bn of Russia’s central bank’s assets in the context of the sanctions related to the Ukraine invasion was a stark signal to those fearing a similar treat by the US hegemon, therefore they decided for increasing gold holdings instead of USD-denominated FX reserves. We expect this trend to continue and some form of commodity-based barter exchange between countries such as China and Russia, with Russian oil delivered against Chinese gold, most likely will be growing in importance in the coming years.

In line with our preference for “bricks & mortar” businesses, as opposed to the financial and to the virtual (Tech) world, we still see value in commodity producers, be it energy or materials, as years of underinvestment have added to scarcity, lifting the price levels of many commodities in the years ahead. We also like the healthcare sector for its secular growth prospects since a growing proportion of household income is spent on healthcare. Thanks to the prospect of further rising yields, the financial sector may be considered an opportunity – we would remain selective here, as growing evidence of a recession will put a lid on valuations as the topic of non-performing loans may grab attention in the short term. Longer-term, such potential weakness could be seen as entry levels.

The end of the crypto winter?

There have been three completed four-year cycles in the crypto space, the downturns of which got coined “crypto winters”. According to said rhythm, we should have seen the lows of the current cycle somewhen around November and December of last year. Lamentably, the outright criminal actions at FTX and its sister company Alameda Research have led to much scorn for the whole of the industry. Many observers now call for more regulation – we would however point at the fact that regulation in some jurisdictions (think Switzerland, think Europe) is already a fact. We note that the defrauding of crypto investors by unsolicited misappropriation of their funds with the exchange took place in offshore jurisdictions (the Bahamas in the case of FTX).

Considering the scale of potential losses, we are almost surprised that the global market capitalization of all digital assets “only” dropped by 25%, despite the daily horror show of new disclosures about the close-knit circle around SBF, the founder of FTX. We take the view that another drop may be in the cards, however that we are close to an end to crypto winter eventually. At the core of the “problem FTX” as well as with other companies in the space that went belly up lies one word: leverage. We have always wondered why investors need to leverage trades in instruments that display historical 50-day volatility spikes north of 100%.

50-DAY VOLATILITY OF BITCOIN AND ETHEREUM

Source: Bloomberg

Conclusion

• After a difficult 2022, we would not expect too much of 2023 in terms of market reversals. The fight against inflation will remain at the forefront of central bank policies, while we expect inflation to subside only gradually and not to levels that were the norm in the decade up to the Covid pandemic.
• Barring further geopolitical mayhem, some form of calming on financial markets may be seen once central banks hint at an end to the hiking path, which may be discernible somewhen around mid-2023.
• Recession will strike both in the US as in other parts of the world (e.g. Europe), putting government finances under strain which may be cause for the bond vigilantes to push bond yields to new highs.
• Commodities will see strong support, even if a global recession and potential fallout from China’s pivot in its Covid-related public health policies could weigh on prices in the first quarter. We would regard these potential price falls as an opportunity to add.
• What was important in 2022, namely to follow a dynamic investment strategy (as opposed to “buy & hold”), will also bear fruits in 2023 as there will come the time to add aggressively to risk assets such as equities likely already this year.

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