Year ahead views and thoughts
The consensus forecast for the Global Economy in 2023 is pretty clear, a peak in inflation and a sharp slowdown in GDP that will be ‘short but not painless’. The associated view for markets, however, is more diverse and largely depends on the extent to which this economic slowdown is regarded as being ‘already in the price’. Most analysis at least implicitly acknowledges that bear markets tend to have two phases; the first is the de-rating phase associated with higher interest rates and a tightening of monetary policy (arguably what we have just seen in 2022), while the second phase is the credit cycle, where the economic impacts of the tightening of policy feed through into lower earnings and thus a second round of weakness. The chief difference in outlook for markets then is the extent to which this second phase will impact 2023. We find ourselves in a relative minority in thinking that while phase one of the bear market is over (albeit a new bull market has not yet begun), the anticipated second phase will be mild or may not even happen, certainly not in the way that the majority see it – based largely on historic analysis of metrics such as yield curves and ‘the Fed’.
Our reasoning is that it really is ‘different this time’, since we have no historical precedent for a decade or more of ultra low interest rates (Zero Interest Rates, ZIRP) being followed by an enforced shutdown of the global economy (Zero Covid) that not only disrupted supply chains to produce temporary inflation pressures when economies were rapidly opened up again, but that also resulted in an enormous expansion of the Money Supply such as to finally produce the inflation the central banks had been attempting to generate for years. As the Fed scrambled to put the genie back in the bottle by collapsing Money Supply growth last year, the recession is now baked into 2023/4 in the same way the inflation in 2022 was baked in back in 2020.
Thus obsessing about the exact level of Fed tightening or indeed whether or not it ‘pivots’ is really to miss the big picture, which is that ZIRP and Zero Covid are both now over and the winners and losers are going to be a function of strength or weakness of cash flow and balance sheets. We are less bothered about the credit cycle because the majority of the benefit of low rates was within markets themselves rather than in the real economy and that has already unwound in 2022 and while some now see ‘value’ in companies and markets associated with ultra loose monetary policy, we do not see the need to get involved. Most western economies didn’t really have a boom, so won’t have a bust, but equally are going to miss out on the attractive returns due to the growth in the rest of the world, the part that didn’t have ZIRP and no longer has Zero Covid – and crucially is not embracing the cult of Zero Carbon. BRI and BRICs are the acronyms for 2023 and the fact that almost none of the mainstream analysis is discussing China or the new world order being established should pique the interest of investors with even a modest contrarian bent.
We read them so you don’t have to. There are a vast number of year-ahead documents circulating from the various brokers, investment banks, Private Banks and research institutes*. Rather than seeking to summarise them, we thought instead, we would try to create our own framework, referencing where they notably agree or differ with our own views and how this may be driving the narrative. In part, their views (unsurprisingly) reflect their underlying client base – Investment Banks are generally more upbeat about markets and the split between equity and bonds usually follows the bias of the bank. Or indeed the writer, for many of these are ‘ensemble pieces’, where the bias of the lead author can sometimes dominate – an economist talks a lot about unemployment and ‘real wages’ for example and produces lots of forecasts of macro variables like GDP and inflation that, if we are honest, aren’t much use to anyone except another economist. Meanwhile a Wealth Management CIO or head of multi asset talks more about portfolio construction, trying to construct some practical solutions. A fixed income specialist always finds a reason to buy bonds (and usually sell equities) and of course vice versa for the equity specialist. Private Equity analysts predict investors turning to private markets, while alternative specialists also tend to tout their own markets. Corporate focussed institutions are historically more economic based and more lagging indicators and probably the gloomiest right now, while Private Banks tend to take a longer term view – as Citi put it “one year is just a ‘moment’ in the lifetime of a portfolio”.
The views of US writers are often skewed in a similar fashion (particularly with respect to Non US economies and markets) that while we might not agree, nevertheless give insights into ‘received wisdom’. Europeans seem more positive on China, but also more focused on Climate change. And so on. None of this is to complain about the bias, rather it is to acknowledge its use in constructing the overall ‘narrative’, the aim of Market Thinking being to try and make sense of the narrative and to navigate it as best as possible.
General Overview
Inflation down, growth down, divergence on whether it is in market prices or not yet.
We start with a comment from the team at ING, who take a scenario approach and note that this year we have the widest range of possible outcomes in years (noting that nobody would/could have forecast a pandemic back in January 2019 or a War in 2021) but for all that, actually on economics, the broad thrust of all the reports is actually pretty similar; the consensus generally is that inflation will moderate and the Central Banks will stop tightening, both of which are reflecting a slowdown already ‘baked in’ thanks to aggressive monetary policy that has already taken place. As we start the year, action in markets such as Oil for example appear to suggest that the recession story is taking precedence, even though most commentators, appear to agree with Deutsche’s sentiments and think the recession will be “short lived, but not painless”. The differences are largely in what this all means for markets, specifically how much is already ‘in the price’. As expected, there is quite a lot of ‘the yield curve predicts a recession, but history says that the equity market must fall’ type commentary from the bond economists, but it is countered by quite a few strategists pointing out that the upcoming recession is already in prices. Interestingly, having just seen a textbook example of what happens when you rapidly expand the Money Supply (the US printed more $s under Covid than in the entire history of the United States) and then having seen that growth rapidly and deliberately collapsed, the majority of the analysis is still Keynesian, focussing on aggregate demand and US labour markets. In the sense that this is Fed-watching and they are trying to anticipate Fed behaviour, this is perhaps useful, but in terms of understanding what is actually happening to growth and inflation it adds little value in our view. After all, we spent over a decade thinking tight labour markets would cause inflation and they never did. What may be happening now is a shift in returns to labour (and thus a compression in margins, but almost no-one is looking at it in those terms.
Consensus is for slower growth and lower inflation, a pause by Central Banks and a weaker $. Bigger differences appear on China, European Energy crisis and how much bad news is already ‘in the price’.
Macro Traders and particularly those heavily involved in Fixed Income see everything as being about the Fed, and much ink is spilled over the likelihood of ‘a pause’ by Central Banks. But we think a pause is all we can expect, such that some commentators (like Barclays) who are warning against expecting cuts are actually throwing up something of a straw man in our view – for while many talk of a Fed Pivot, it is not a central view and no one is expecting cuts by central banks to drive markets higher in a return to the QE world. What is clear, however, is that higher costs of borrowing for some mean higher returns on cash for others. A redistribution of returns, just as there is a redistribution between capital and labour.
Probably the biggest macro disagreement is on China, where, if they consider it at all, the Europeans seem to be much more optimistic than their US counterparts, almost certainly reflecting the different political environments and in some senses what people ‘want’ to happen, rather than a best assessment of what is most likely to. However, in our view, the fact that the world’s second biggest (arguably biggest) economy is ‘coming back on-line’ should be far more prominent in the analysis than it actually is. De-Globalisation is seen by some (Like Fidelity) to be more about opportunities in Markets like Mexico and Indonesia, coming from a re-shoring (ie US centric) point of view). This is valid and supports a general EM case, but China opening up is really the key variable for 2023. It is of course already underway (a few of the notes written back in November are now behind events, having predicted nothing happening until Spring), which exposes another bias in many of these reports – the assumption that US growth and employment are the key variables for all economies and markets.
Growth and Inflation
Theme is Balance Sheets and ‘Back to Normal’
The key macro issues for most of these publications tend to be growth, inflation and the Fed, with economists and Bond experts focusing most on these three, while other do so mainly as part of the overall ‘process’ rather than an end in itself. As such, tables of comparative economic forecasts and indeed market target levels are not much help in our view. Almost all reports tend to the view that inflation would modify this year – and as JP Morgan put it there will be ‘an end to the panic’- and that growth would be generally weaker. Goldmans was upbeat on the US relative to Europe and, along with Credit Suisse and Apollo, focus on the US employment data being ‘strong’. This is probably a bit of ‘Fed Watching’ as Jerome Powell has implied the Fed think the employment numbers are very important, which raise our main concern for western economies; that the Central Banks conduct policy in response to date releases rather than allowing for leads and lags (as recent events should have reminded them exist!) and will thus ‘over-correct. (Fidelity among others make this point). In fact, the US labour market is actually one area we consider as possible for a ‘surprise’, ie that the data is misleading and there is a lot of measurement risk, especially around multiple jobs, such that it is actually weaker than many currently assume.
Against that Apollo make a good point (which we do agree with) about the excess savings accumulated during Covid by US consumers, which to us is a better supporting variable than labour market ‘tightness’ and the $3trn of cash in US savings in US checking accounts, while not evenly distributed, is probably better than the traditional measures of the wealth effect and will nevertheless provide a lot of ‘balance sheet support’. As noted, consensus is for a recession, with Apollo pointing out that consensus on Bloomberg for US, UK and Europe are 65%, 90% and 80% respectively, all up from around 15% a year ago. From the year ahead pieces, we would say that the key difference is that the US brokers are more optimistic about their home economy in general and that for equities, the difference is in how much is already ‘priced in’, with JPM and Deutsche in the ‘priced in’ camp and most others less so. For our own view, we see an overall theme of ‘normaliastion‘ with growth being a function of balance sheet strength – both at the household and corporate level. The above mentioned high level of cash deposits in the US is supportive of ‘normal’ levels of household spending, while the return on those cash deposits (in excess of 4%) will form an important part of household balance sheets going forward. The inverse of that is that highly indebted households and businesses will face, at best, a large call on available cash flow for debt financing, at worst, bankruptcy. Note however, that this is ‘normal’ levels of interest rates, normal businesses and households should be able to survive, this is not classic credit cycle high rates to cause a recession.
On Europe, the US banks diverge, Goldmans are more pessimistic on a European recession, while JP Morgan is more optimistic about Europe’s ability to diversify its supply chain. Morgan Stanley also sees an improvement in inflation and is consistent with our own view that higher rates in Europe will have diverse impacts, depending on household and corporate balance sheets. We would also agree with Fidelity that the composition of the UK FTSE gives exposure to positive global growth trends at attractive valuations and would on the other hand agree with JPM that the risks to Scandinavia housing (and their Banks) are under-appreciated. Europe as an economy looks similar to the argument that we make for European Banks,(see Money in the Bank(s)) they won’t have a bust as they never enjoyed much of a boom. Interestingly, the European houses don’t have much to say on Europe we found. Barclays are probably the most gloomy and represent the consensus ‘bear case on everything’. They are focusing on ‘no end’ to the war in Ukraine, further energy headaches for Europe (in contrast to JPM), a forecast of sclerosis in China, a collapse in US housing and ‘dizzyingly fast’ pace of rate rises thanks to inflation. Credit Suisse are almost as cautious and repeat much of the same points But as many of the more long term, wealth manager targeted articles, including Citi Global Wealth, point out, markets lead economies, not the other way around. Nevertheless, from our own observations in Hong Kong, for many global investors Europe remains in the ‘too difficult’ box, while for investors outside of Asia, China is in the same position.
China
Some believe that China’s growth will be almost as slow as during Covid (Barclays) or that the recovery will be shallow (HSBC Private Bank). Indeed, such a bias leads HSBC, like Goldman, to prefer the US, which we are less enthusiastic about – although they have upgraded the stock market in China – what they refer to as their ‘silver lining’. The European Banks seem more positive on balance, Deutsche Wealth for example seeing ‘significantly more dynamic growth”.
China opening up is one of our key themes for 2023, and is happening faster than many predicted. This of course is leading the increasingly widespread anti-China rhetoric in the mainstream media to switch from how terrible it is for China to maintain Zero Covid, to how terrible and reckless it is to open up again. (There is literally no pleasing some people). The fact is that China re-opening is not just a decision on Chinese equities, far from it, it is essentially re-engaing one of the two main engines of the global economy and will have implications across all asset markets – not least commodities. It is also important to recognise that the nature of Chinese growth is continuing to change. Blackrock for example see China “de-emphasizing economic growth in the pursuit of self-sufficiency in energy, food and technology”, which we would agree with, while Paribas make a key point that there is little evidence of global and certainly not regional de-coupling from China – as they put it “One can run, but not hide from the Middle kingdom”.
The independent analyst Pepe Escobar makes a strong case for a return of the BRI this year, helped by the return of the BRI conference after a Covid induced hiatus. Plus, of course, the new role for the BRICs, or indeed the BRICs+ as it is known, as the initiatives from China around Western Asia and the Middle East accelerate in the wake of the geo-political tensions and the weaponisation of the US $ system. To adapt a phrase similar to that used by Paribas, “You can ignore China, but it wont ignore you“.
BRI plus BRICS+ to dominate 2023/4
Asset Allocation
On currencies, the consensus seems to be that the $ has indeed topped – although some think it could still overshoot – but almost all are talking about the cross rates on Euro, Yen and Sterling, whereas we think there are much more interesting trends likely to emerge across the Asian currency crosses. Also, while we agree that the Central Bank actions going forward are likely to manifest themselves mainly through currency markets (discount rates having already adjusted for longer duration assets), we should not overlook the fact that if derating and deleveraging is now largely over, then the $ overshoot to the upside associated with forced buying back of $ shorts and ‘over-hedging’ (a significant factor for the Yen this year) will also have ended. We also think that, as supply constraints ease, onshoring increases and inflation pressures subside in the US, that the administration might like to see a competitive dollar and that with Geo-politics making selling Treasuries to rich economic and political competitors a lot harder (!) and the Fed likely to have to start printing again to buy the growing supply, that they just might get what they wish for. To be clear, predicting long term trends in currencies to emerge on short term time frames is a recipe for disaster, but anticipated weakness in the US$ is definitely helping to drive some asset allocation decisions – such as out of (some) US assets into EM and Asia in particular – as well as into quasi currencies such as Gold.
Most commentators with a bond bias remain in some form of shock about the end of their great bull run, which after all has probably lasted their entire career and are claiming to have now found ‘value’, but other than cash as an asset, we struggle to see the role for bonds for any but those forced to own them by regulators. The issue of high grade credit over equity seems to rely on a false premise – that ‘risky’ equities are the only alternative to ‘high grade’ bonds. The universe of available corporates (especially outside the US) is often in areas that, almost by definition, are over-leveraged, while the high grade, or quality equity alternatives with strong balance sheets, cash flows and dividends are all paying as high if not higher dividend yields with far more exposure to upside surprise. It’s rather like preferring consumer cyclical equities to junk bonds – a choice you don’t actually need to make. Moreover, if we accept the premise that a bear market usually has two phases – the liquidity and deleveraging phase (which we would argue we just saw in 2022) followed by a Credit Cycle phase (which is most expectations for 2023), then it seems inconsistent to be pushing for high Yield, or even high grade, credit at this point. If you don’t believe there is a credit crunch coming, then why not have equities? If you do, why have credit?
Interestingly, some Private Banks, (e.g. HSBC) still like hedge funds, seeing them as benefitting from Volatility, divergence between markets and rising income on their cash balances. While, largely, agreeing with the first two points, – albeit we don’t see Macro Hedge funds doing as well this coming year as in 2022 on the basis that those were large, leveraged and directional trades – we would query the third point in cash. The other side of higher cash earnings is a higher cost of leverage, which is often essential to the profitability of the trades. As such, we would qualify their recommendations – towards a core allocation to private companies and real estate – with a caution about the risks of leverage combined with illiquidity – two sources of risk both of those areas have in common, but which are rarely properly acknowledged. As things normalise, the ability to repeat previous profitable trades, especially those based on spread and carry, starts to disappear.
Thus to incorporate the above into our standard monthly framework:
Short Term Uncertainties
Understandably, most of the authors discussed above are somewhat ‘gun-shy’ after broadly upbeat publications a year ago ran into one of the worst years for markets in memory, which means there is a bias towards ‘quality’ and low risk in recommendations, somewhat similar to the ‘wait and see’ approach taken in early 2009 after the GFC . The confidence indicators behind our Model Portfolios remain neutral to positive at the factor level, but some of the longer duration themes have once again stepped back, leading us to raise cash levels during December once again. This is consistent with our view that the Bear market may be over, but a new bull market has yet to begin. In effect, risk premia remain elevated, favouring commodity and cyclicals over long term growth. In commodity markets themselves, the short term traders have embraced the consensus recession narrative as we start the year and we have seen oil price weakness, while the chatter about Fed pivots from traders has faded, leading to the $ stabilising after its recent falls, while cross currencies like Euro and Sterling, as well as pseudo currencies like Gold have consolidated their rallies. There appears to be some rotation out of US assets into overseas, but nothing significant thus far. JPM Morgan is quite closely aligned with our own views here, that both bonds and equities have already discounted most of the economic conditions we are facing, suggesting opportunities for stocks with strong earnings prospects that now look cheap and highlighting EM. BNP Paribas meanwhile show a graphic where almost every major market outside of the US is at the bottom end of their 10th to 90th percentile range on forward PE over the last 15 years but (curiously) conclude in the title that “Equities are not cheap”. Outside of the US they certainly are.
Medium Term Themes
In terms of our big themes for the year, Morgan Stanley discuss in some detail the likely continued outperformance of Equal weighted over market cap weighted indices (something we ourselves have looked at a lot (see December Market Thinking) and also believe will continue into 2023, as well as noting that non US stocks started to outperform as the $ peaked in September).
HSBC Private Bank like short dated bonds here and, like us, see a weaker $ as the most likely consequence of peak US rates. They also remain upbeat on ESG, although here we would differ, suspecting that the performance issues around a basket that was notionally ESG, but in reality a ‘long tech/short energy’ play, which obviously had a terrible year in 2022, will continue to make unconstrained investors reluctant to shift their portfolios any more into this area. By contrast, the team at the Blackrock Research Institute, perhaps not surprisingly given they are headed by ex Swiss Central Banker Phillip Hildebrand, are underweight Developed Market equities believing things are not in the price. They like short dated bonds and mortgages and high grade credit which they see as ‘compensating for recession risk’. In this they are consistent with other, bond focussed teams (who are always bearish equities!) and we would question whether the yield on high grade bonds is better than a higher yield on high grade equities. It presumably depends on other constraints. Their tactical bear on Equities is also associated with a view that Central Banks will ‘over tighten’ in the near term.
Long Term Trends
Look East. Almost all the reports discuss the ESG and sustainability ‘trend’, which is certainly a trend for the investment industry – the more they are ‘invested’ in the world of ESG, the larger the emphasis. Paribas stands out in this regard, talking of ‘a journey to net zero investing’ – although they do discuss other Thematics as well and we would agree in their analysis on China, that Beijing aims to use its growth impetus to drive domestic and regional growth. Equal and opposite (and of much more interest to us) is the discussion on the importance of energy and very much agree with the team at Nat West about the importance of nuclear.
Citi meanwhile discuss another of our longer term themes – a greater separation between east and west and this is something that is also picked up by Zoltan Pozar of Credit Suisse (in a separate year ahead piece) where he points out the alternative institutions being built in ‘The East’. For him, the Shanghai Co-operation Council is “The NATO of the East”, the BRICs are the “G7 of the East” and the Belt and Road Forum is the WEF (World Economic Forum) of the East”. The fact that Turkey, Iran and Saudi Arabia have all applied to BRICs and that Saudi and Qatar are attending members of the SCO are important moves that have received little attention.
In effect, he points out that the US has alienated the OPEC members with 40% of the world’s provable reserves (Russia, Iran and Venezuela) and is heavily courting the Gulf Co-operation Council which supplies the next 40%. More importantly, China is increasingly paying in Rmb, which as we have discussed before, thanks to the Shanghai Gold exchange is effectively ‘as good as gold’. India, meanwhile, has been paying for some of its oil in Dirham, which is interesting as the UAE is part of what is perhaps the most interesting long-term development in trade finance, which is the so-called M-Bridge Project. The idea here is to use blockchain technology and Central Bank Digital Currencies to create a trading hub outside of the $ (and thus US Policy controlled) banking system.
The new systems emerging do not so much mean the end of the $, as the end of the Petro$ and the birth of the Petro Yuan.
To talk of alternative Reserve Currencies is both too early and also something of a Red Herring, the economic impact right now is going to be the shift in trade patterns and settlements. Importantly, we would disagree with the consensus view that China needs to export cheap goods to the west for economic growth reasons (and thus is forced to recycle the $s it earns). Rather, we see it as historically needing to earn the $s in order to buy the fuel to grow its economy. If, as is increasingly the case, it can simply use Rmb (which it can print if it needs to), then the level of $ transactions falls sharpy and the 300x leverage in the FX markets shrinks accordingly. (Global trade is around $6tn annually, much of which is in $s. FX volume – leveraging off the underlying- is around $6trn every day.. Reduce the underlying and the FX market shrinks alongside it.) At the same time, the world needs to recognise that China is not only going to be an increasingly large buyer of Oil and Gas (it just signed a 20 year deal with Qatar) and thus continue to put upwards pressure on global prices as the economy not only recovers but expands, but that with Geo_politics increasingly forcing China out of its larger markets in ‘the West’ it will become increasingly dominant in ‘The Rest’. Most western observes appear to have overlooked the December initiatives by Xi in the Middle East.
The role of Iran. To return to Pepe Escobar’s analysis, here he points out how the integration of Iran into ‘The Rest’ will tie in with the BRI. Iran is already a member of the Shanghai Co-operation Organisation (SCO) and has signed a free trade agreement with the Eurasia Economic Union (EAEU) – the post Soviet States of Russia, Armenia, Belarus, Kazakhstan and Kyrgyzstan and as Escobar points out Iran is now arguably the interconnector for the INSTC, the International North South Transport Corridor that connects Russia, India and, ultimately, Europe.
Iran is at the heart of the new International North-South Trade Corridor. And it won’t be using $s
After more than 70 years of the Washington Consensus model of economic development based around institutions like the IMF, World Bank and, of course, the US dollar, the end of ZIRP and the end of Zero Covid is going to favour those economies and institutions embracing the BRI and the INSTC, countries that will not be constrained by the diktats of Zero Carbon, nor restricted by the US$ financial infrastructure.
- * Inter Alia, Goldman Sachs, JP Morgan, Morgan Stanley, Bank of America, Blackrock, HSBC, Barclays, Nat West
- Citi, UBS, Credit Suisse, BNP Paribas, ING, Apollo Global Management, Wells Fargo, BNY Mellon, Fidelity and Lazard
