The title of our February column was a question: will markets pass the first test of 2023? One month later, the least we can say is that it wasn’t a triumph. The year-to-date return of global stocks halved in the meantime from almost 10 percent as we write. It was even worse for government bonds, from +5 percent in early February to -1 percent now, or for gold, from +6 percent to -2 percent.
So what happens, and why?
As we repeatedly wrote, 2023 is all about the relative trajectories of inflation and growth, with central banks’ reaction function in between. Persistent inflation requires more pressure on growth, and reciprocally, strong growth puts the wind in the sails of inflation.
After decades of focus on growth, and growth only, in a world dominated by the disinflationary forces from globalisation and technology, the growth-inflation trade-off is back. Central banks are not in an easy position: their previous support is blamed for having caused inflation, and they now must fix it, upsetting economies, governments, and markets.
The year started with hopes of a miracle: receding inflation with resilient growth. The combination allowed for central banks to pause their tightening, without too much damage. This perfect scenario explains the strong January rally of everything.
But the miracle turned into a mirage. Economic activity surprises on the upside: from job creations in the US to PMI surveys everywhere: growth is stronger than expected, especially on services. Good news for the economy… is bad news for inflation. The rise in prices, which started with goods and then moved to energy, is now particularly prominent in core services.
This is where the risk of a wage-price spiral is the most critical. As a result, even before central banks formally reacted, markets had to brutally reprice their expectations for policy rates. The Fed was supposed to plateau around 5 percent and future markets were even pricing-in rate cuts for the end of the year. Not anymore: implied expectations are now closer to 5.75 percent, with no inflexion in sight.
Importantly, it’s not just about the level of tightening, but also about its pace. The US Fed had started to take smaller steps with a quarter point increase only in February. The risk is that they could go back to half a point as early as on March 22nd.
Fed chairman Powell said it explicitly: they are data-driven, and they will not hesitate if needed. Markets wouldn’t like it: beyond the absolute level, which is digestible, markets hate uncertainty. “Adapting to Unpredictability” is the title of our 2023 Global Investment Outlook.
So we have good news on growth which translate into bad news for inflation, supporting more tightening ahead from central banks. What are the implications for markets, and how far are we in reflecting them in the prices?
Let’s start with the logical ones. Yields from government bonds across the Western world are rising, especially on the shorter maturities which are more impacted by central banks’ policy rates. Then, as higher interest rates command lower equity multiples, for a simple reason of relative valuation, stocks from the West gave back half of their previous gains.
This is justified, even more so as more tightening now means a higher risk of recession later, which would affect future earnings. Another perfectly explainable fact is to see gold price falling into negative territory year-to-date: gold is less competitive compared to other stores of value, starting with money markets.
And then, there is the rest. Let’s look into the bonds universe. The risk of a future slowdown, linked to central banks’ tightening, is perfectly reflected in the inverted yield curve (a 2-year government bond yields 5 percent while a 10-year is close to 4 percent). But the excess returns from riskier segments of fixed income, such as high yield corporate bonds, are nowhere near recessionary levels: the so-called “spreads” are just at historically average levels.
This is not logical as these bonds would be the most affected by a severe downturn which, according to the predictive power of the yield curve, has a high probability to happen down the road. Another curious feature is to be found within developed stock markets: the best sector so far this year is technology, which is theoretically and historically one of the most negatively impacted by high interest rates.
And finally, let’s have a look at the regional divergences. Real GDP growth in the Western world is expected to be at best around 1 percent this year, while CPI inflation could be anywhere between 4 and 6 percent. By comparison, China is expected to grow by 5 percent according to its official guidance, while year-on-year CPI as of February is at 1 percent. Do stocks from emerging markets, which are also cheaper, outperform? Not at all, they underperform their developed peers.
You may have already guessed that we favour defensive bonds over riskier ones, and stocks from emerging markets over the Western world. As our keyword for 2023 is unpredictability, we would certainly not guess anything on the timing, but we are confident that these anomalies will correct. They are opportunities for fundamental and patient investors.
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