Investment themes for 2023
The UK economy beat expectations at the end of 2022, expanding 0.1%, with a boost from the World Cup’s unseasonal appearance in November and December. While this shot of good news might not be enough to end the financial gloom, it is nonetheless a welcome glimmer of positivity. At Holden & Partners we are looking at the key trends for 2023 and factoring them in to the decisions we make.
Global Slowdown
The current global economic climate is a far-cry from the goldilocks environment we found ourselves in throughout much of the previous decade. Economies now face the consequences for taming inflation, as last year’s aggressive interest rate rises placed a stranglehold on economic growth. Inflation appears to have peaked last year, with input costs such as shipping and energy costs declining from 2021 highs, but it is forecast to remain far above target rates.
The managing director of the International Monetary Fund (IMF) has predicted that one-third of the world economy will be in recession this year, as the US, European Union, and China – the three largest economies and global importers, simultaneously slow down.1 The technical definition of a global recession is disputed, and whilst it is unlikely we will see global growth meet the strictest criterion by falling into negative territory for two consecutive quarters, it is very possible that GDP growth over the year could decline below 2.5% (weakest criterion).
Rising interest rates to combat inflation is a common stage in the normal business cycle, however the three preceding years of abnormal economic conditions has thrown economies off-course from traditional business cycles.
Lower growth and stubbornly high inflation are two of the three requisites for stagflation, an undesirable economic state as policy measures to increase growth exacerbate inflation, and measures to subdue inflation slow growth. The third requisite is high unemployment, yet so far, labour markets have remained surprisingly resilient, fuelling hopes for a soft landing should labour market shortages stop widespread job losses. Higher interest rates increase the cost of debt for corporations, in this environment quality companies with economic moats and strong balance sheets will outperform.
Mixing analyst forecasts with prices of financial market securities offers an insight into expected future market and economic conditions. In the US, these forecasts and pricings imply different environments. US bond markets are pricing in rate cuts in 2023, yet many economists are of the belief that rates will remain “higher for longer”. The key difference is whether the Federal Reserve will raise interest rates too fast, or too high, which will lead to overtightening and subsequent economic weakness and interest rate reductions. Even after GDP and earnings forecasts were slashed in December, current market pricing reflects economic stagnation or mild recession, rather than a deep contraction, which leaves downside risk should the recession be more pronounced than currently expected.
Leading economic indicators imply a high probability that the UK and Eurozone are currently in a recession. The energy crisis has been somewhat eased by warmer winter weather conditions, but the continent still faces high inflation and continual repercussions from the Ukraine Russia conflict. China is a notable exception among major economies, with strong forecasted growth in 2023 as the economy re-opens, despite a resurgence of COVID cases following the end of the Zero Covid Policy.
Are Bond Markets Finally Attractive?
Following a forty-year bull market in government bonds, yields had reached a point where they could no longer deliver income, a key characteristic of a bond. In fact, an astounding 90 per cent of all global government bonds at one point had yields of less than 1 per cent, driving investors to take on more risk in extended credit sectors that had far higher correlations to stocks.2 On the contrary, in 2022 we saw a run-up in bond yields, particularly at the short end of the yield curve, as global central bank’s tight monetary policy drove bond prices down (bond prices move inversely to bond yields).
Moving into 2023, the consensus among most economists, investors and policymakers is inflation has peaked and will trend downwards to central bank targets but not reach them.3 This means we will likely see a slowdown in central banks’ interest rate hiking cycle. Nonetheless, with the market expecting interest rates to reach around 5 per cent in the US, near 4.5 per cent in the UK and close to 3 per cent in the eurozone,4 it is foreseeable that by the second half of 2023, real yields will turn positive, something investors thought unimaginable 2 years ago and a situation they will relish.
The lure of corporate bonds is also strong as they have higher yields than government bonds. Particularly attractive are short-term investment-grade bonds issued by large, healthy companies with low levels of debt compared to earnings. Alternatively, investors can look towards investment-grade credit funds to provide a healthy return. Like any investment, however, there is always a risk and in the short term, the corporate bond market may face a rough time.5 Financial conditions will continue to tighten in 2023 as central banks lagging monetary policy starts to filter through the economy highlighting further downside risk to growth. While bankruptcies may increase in this environment, companies have fortified their balance sheets by refinancing debt at lower yields, likely protecting them from a slowdown in growth.6
The End of Globalisation?
Geopolitics took centre stage in 2022 significantly impacting the global economy and financial markets. This, however, isn’t a recent phenomenon because of Vladimir Putin’s barbaric invasion of Ukraine, cracks started to appear in 2016 with Brexit and in 2017 with economic tensions emerging between the United States and China on tariffs and trade.7 Nonetheless, 2022 is the year the deglobalization trend continued to gather steam. Putin’s invasion of Ukraine meant Europe stopped buying cheap energy from Russia affecting its ability to produce good-quality manufactured goods to export around the world.8
The United States made significant moves to reshore its microchip manufacturing, escalating the tensions between the United States and China.9 Moreover, China looked to strengthen ties with the Arab nations by inviting them to trade oil and gas in yuan,10 a clear sign China wants to drift away from the global west.
A side effect of deglobalisation is inflation. During globalisation, we saw China, with its cheap labour combined with its cheap input costs, sell cheap goods to western economies, and as mentioned above we also saw Russia sell cheap energy to Europe which it then used to produce goods for export all the while any excess earnings got invested back into G7 countries. As geopolitical tensions have risen, further fuelling deglobalization, more countries are looking to reshore their supply chains, and while this makes sense from a security point of view, labour costs, regulation and energy costs mean it will lead to increases in costs. The ability of companies to pass on these additional costs will produce clear winners and losers with some sectors coming to the forefront that have been out of favour with investors.11
Undoubtedly, the deglobalization trend will continue into 2023 as global economies reorganise to pursue their own interests, however, this is a long-term phenomenon that will be played out over many years.
Regulation and Sustainability
Regulation will continue to play a large role in sustainable investing in 2023, and the continent’s regulators intend to waste no time as we start the new year. Last year the FCA released their consultation paper on Sustainability Disclosure Requirements (SDR) and investment labels, with the end of January being the deadline for responses, and the final rules and guidance published in June.
While the proposal aims to help consumers navigate the market of sustainable funds, build transparency and trust, and to hopefully make the growing issue of greenwashing a thing of the past, it is still unclear how the proposals will impact the landscape for sustainable investing in the short-term. How will fund managers deal with the additional requirements? Will we see dark green/impact funds be labelled down? How will passive investments be classified?
Meanwhile, the EU’s Sustainable Finance Disclosure Regulation (SFDR) level 2 rules come into effect at the start of the year, introducing the need for fund managers to supply detailed sustainability-related disclosure obligations, along with completing mandatory reporting templates. As a result of these stringent requirements, Q3 see 380+ funds change SFDR status, with 41 of those being Article 9 (funds that have sustainable investment as its objective) downgrades.12 Many more announced plans to ditch the Article 9 classification in the final quarter of 2022.13
This highlights the uncertainty introduced by the regulation, and perhaps SFDR gives us an idea of what to expect from the FCA’s proposals. The answers to the above questions should be answered as the year progresses, however.
‘It is understandable that times of uncertainty cause concern and anxiety. This is why at Holden & Partners we have a dedicated team of investment professionals that are constantly monitoring the markets as well as macroeconomic conditions to ensure that your portfolio is positioned in the best manner possibly’.
3. The World In 2023: What Is Priced In? | ZeroHedge
4. https://www.reuters.com/markets/rates-bonds/terminal-confusion-boe-rates-mike-dolan-2022-12-07/
5. https://www.morningstar.com/articles/1129526/where-to-invest-in-bonds-in-2023
6. https://www.blackrock.com/corporate/literature/whitepaper/bii-global-outlook-2023.pdf
8. https://themacrocompass.substack.com/p/the-long-war#details
10. https://moderndiplomacy.eu/2022/12/12/china-arab-summit-a-paradigm-shift-in-gulf-states-policies/
11. https://www.ftadviser.com/investments/2022/12/09/how-deglobalisation-will-impact-investment-returns/
12. https://www.morningstar.com/en-uk/lp/sfdr-article8-article9