Market View Too Rosy – For Now

Transcript

Equity markets are up in 2023, fueled by China’s reopening, falling inflation and lower energy prices. Our strategic, long-term views are positioned for this. But investors with a shorter horizon should be wary.

1) Long run vs. short run

We’re in a new regime of greater macro and market volatility. But that doesn’t mean it’s a permanent persistent bear market.

We see our preferred gauge of equity valuations as reasonably valued relative to what we expect in five to ten years’ time. That means stocks should outperform bonds on this horizon.

2) Market outlook too rosy near term

But investors with shorter horizons of 6-12 months should be wary. Recession is foretold, in our view. Central banks are deliberately causing recessions to bring inflation down, not riding to the rescued as in the past. We think markets are positioned for a rosy outlook too soon – and it will get worse for risk assets before it gets better.

3) Why we see yields rising

Our long-run views have favored inflation-linked bonds over nominal government bonds. The events of 2023 give us more conviction in this view.

Inflation was always going to come down as some of the pandemic drivers reversed. What matters is where it settles. Market pricing does not reflect what we see as inflation settling closer to 3% than 2% in the U.S.

This means long-term yields should rise from here, hurting nominal [government] bond returns.

The events of 2023 have reaffirmed our strategic views. But investors with short horizons should be cautious – it could get worse before it gets better.

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Markets have leapt ahead this year, driven by China’s reopening, falling energy prices and slowing inflation. This has spurred hopes of a soft economic landing, plummeting inflation and interest rate cuts. We see markets vulnerable to negative surprises – and unprepared for recession. This is why we are underweight developed market (DM) stocks in the near term. Yet, the developments reinforce our long-term views and the importance of an investor’s time horizon.

Notes: The chart shows our asset views on a 10-year view from an unconstrained U.S. dollar perspective against a long-term equilibrium allocation. This material represents an assessment of the market environment at a specific time and is not intended as a recommendation to invest in any particular asset class or strategy, a forecast of future events nor a guarantee of future results.

An investor’s time horizon is key when gauging how 2023 developments so far affect investments. These events have upped our confidence in our strategic views on a horizon of five years and more. Economic risks like a closed China and ultra-high inflation have lessened, further underpinning our strategic overweight of stocks, as the chart shows. Equity valuations look reasonable versus our long-term expectations. The stock rally hints at how markets will likely react once inflation eases and rate hikes pause, buoying prospects for long-term corporate earnings. Yet, before this outlook becomes reality, we see DM stocks falling when recessions we expect manifest. We think the U.S. economy’s 2023 calendar year growth will then be positive. Investors with a longer-term investment horizon can position for the rebound now but could see more pain to come in the near term.

We may turn more positive on stocks when the damage we see ahead is priced or our assessment of market risk sentiment shifts. For now, the fading risks after this year’s positive developments are key to our strategic views. Case in point: inflation. We have always expected it to fall as pandemic drivers – like consumer spending’s shift from services to goods – reversed. What’s key is our view of U.S. inflation landing closer to 3% than the Federal Reserve’s 2% target. Markets aren’t pricing that in. Plus, longer-term trends like aging demographics, geopolitical fragmentation and the energy transition mean inflationary pressures will be higher than in the past. Treasury yields are falling further away from where we think they’ll climb to in the long term as investors demand more term premium or compensation for the risk of holding them amid persistent inflation and heavy debt loads. We don’t think nominal sovereign bonds can diversify portfolios anymore, and our preference for inflation-linked bonds is stronger given 2023 events. We see stock returns offering more compensation for risk than bonds.

Near-term risks

Yet, investors with shorter investment horizons should be wary, in our view. Falling inflation has raised market hopes for rate cuts this year, but that optimism may be built on shaky ground. We don’t see rate cuts even once recessions hit. The reason: central banks are deliberately causing them to try to push inflation down to a tolerable level, we believe. We see them keeping rates higher for longer as a result. We think recessions are more likely in developed economies given the lagged effect of rate hikes. China’s reopening could support global growth. We see China’s economic growth above 6% in 2023 despite its shrinking trade activity. But this cushioning of global growth would temper DM central banks’ efforts to crush economic activity to try to get inflation down to target, in our view. DM recessions should be the key focus tactically. Yet, markets don’t appear to price in that outcome. We think that makes them vulnerable to more negative surprises – and volatility – in 2023.

Our bottom line

Time horizons matter – a lot. We’re strategically overweight DM stocks because we think downside risks have lessened, boosting potential long-term returns. Yet, we see near-term risks tilted against DM stocks, with earnings growth forecasts not fully reflecting the recessions ahead. So we’re underweight tactically and prefer emerging market equities. We like public equities over private growth assets and expect entry points to grow more attractive. We’re underweight long-term government bonds tactically and strategically, as we expect fewer diversification benefits and a rise in yields. Our expectation for persistent inflation is why we like inflation-linked bonds on both horizons. We like high-quality credit for income in both short- and long-term allocations. Look out for a quarterly update to our strategic views soon.

Market backdrop

Global stocks paused from their rally this year and government bond yields steadied from their drop. Surprisingly weak U.S. retail sales and industrial production revived concerns about recession. Still, Federal Reserve and European Central Bank officials made the case for further rate hikes. We think investors betting on Fed rate cuts later in the year are likely to be disappointed – even as a recession is foretold and we start to see more economic damage from their policy overtightening.

We’re looking at flash PMIs for signs of recession in the U.S. and Europe. We will also be watching the U.S. PCE report for more signs of the spending shift back to services from goods and how that is affecting the Fed’s favored gauge of core inflation, as well as the overall strength of household spending.