Investment Outlook – May 2023

The latest outlook from our specialists on 2023’s key investment themes

Towards the end of last year, we gazed into our crystal ball to see what the future held for investors. Unsurprisingly, we concluded that the investment landscape was very hard to predict, forcing investors to try to balance a difficult equation. On one side we could see an uncertain investment outlook and market volatility likely to remain high. However, on the other we could take comfort in the fact that the medium-term prospects for portfolio returns had improved, following a sharp drop in the price of investment asset valuations, as both bond and stock markets uncharacteristically fell together during 2022.

Our main challenge was that several economic and financial market questions were still unanswered as 2022 ended. We hoped that as 2023 progressed we would be able to answer those questions and gain a clearer view of the investment outlook.

Now, having just worked through the first quarter of this year, it has become clear that it is still impossible to give definitive answers to those questions. In fact, several fresh questions have appeared.

In this edition of Investment Outlook we provide an update on all the key factors driving the global economy, inflation, and interest rates, while also describing our client portfolio strategy and how the future for portfolio returns is shaping up.

Following on from our previous Investment Outlook, we are continuing to evaluate five key themes, or ‘pillars’, that will affect our investment decisions in 2023. These are:

• The global economy
• Inflation
• Interest rates
• Corporate earnings
• Market valuations and investor positioning.

Theme 1 – The global economy

Weeks where decades happen…

During the COVID-19 pandemic, we recalled the famous Vladimir Lenin quote that “There are decades where nothing happens and weeks when decades happen.” Already, 2023 has felt like one of the latter periods, contributing towards a decade that has earned the moniker the ‘turbulent twenties’ compared with the previous decade, which could have been called the ‘easy tens’.

The world, as we’re sure you don’t need to be told, is a complicated place. We have sadly left behind a decade of relative macroeconomic predictability – even if it didn’t seem so at the time – and entered a period when we are experiencing a completely new paradigm for economic growth, government debt, inflation and monetary policy. Mix in worsening geopolitical tensions between the US and China, the war in Ukraine, increasing societal unrest and, of course, the pandemic itself, and we are left with a recipe for volatile outcomes in the global economy and financial markets.

Still stuck in the twilight zone

Throughout the latter stages of 2022 we described the global economy as being in a twilight zone, where it was particularly perilous to forecast the immediate outlook. We weren’t the only commentators unable to achieve precision, and towards the end of last year the investment industry was split on a variety of different economic outcomes for 2023. While we still can’t be totally certain, in the short term it appears that the global economy is managing to avoid the worst-case scenarios predicted for it towards the end of 2022. Looking much further into the future is harder.

All the ‘c’s‘ … except ‘certainty’

The words we have most often used to describe the global economic outlook this year are ’confusing‘, ’complicated‘ and ’contradictory‘. One of the fascinating dynamics is the different experiences of the three key economic regions, namely the US, Europe and China-led Asia. We are witnessing a rare decoupling and desynchronisation of economic fortunes, due to the after-effects of the pandemic and the different problem-solving approaches taken by governments and central banks in those areas.

The US starts to stutter

The US is clearly slowing down towards ’stall speed‘, with a range of conflicting factors influencing economic growth, and we expect very slow or no growth for the rest of the year. Unfortunately, we cannot tell with any certainty how the effects of the rapid rise in interest rates seen in the last year will affect the American economy. We have already seen recessions in those sectors most sensitive to rising rates, such as housing, and those susceptible to weakness in the face of US dollar strength, most obviously manufacturing and certain exports.

For now, the US consumer is still in fine health, with some lingering savings from the pandemic available and a tight jobs market providing confidence. How long those powerful factors behind consumption will persist is open to question and something we are monitoring closely.

Better times in Europe and China

The news from Europe has been significantly better than most pundits were expecting, not least because a warm winter has allayed fears of energy blackouts and an industrial recession. We should also note that the pandemic recovery programmes are only now starting to ramp up across the Channel, which should support growth later this year.

Given its heavy reliance on exports, Europe would have suffered from a continuation of China’s zero COVID-19 policies. However, it now appears more certain that China has started to reopen rapidly, with the Xi administration completely abandoning their previous zero tolerance approach, which was a major hindrance to economic activity at home and abroad. This is a big deal for global economic growth, even if the recovery in China is unbalanced. The initial recovery has been more focused on industrial activity over consumption, with confidence among Chinese citizens still understandably brittle.

In short, the combined growth of the global economy is unlikely to be very strong and will be unbalanced, but it is certainly better than many feared a few months ago.

Theme 2 – Inflation

Inflation prospects are improving but the outlook is still uncomfortable

Last year’s greatest market concern was over inflation, while the one note of certainty for 2023 was in our belief that inflation peaked towards the end of 2022 and will fall this year. That’s the easy part of the discussion, but now the key questions are:

• How pronounced will this trend be?
• How quickly will we reach levels of global inflation that central banks are comfortable with; we don’t yet know what that comfort level for central banks will be, although we suspect it will be higher than their own 2% annual targets.
• What does this mean for the 2023 inflation forecast?

The early signs from inflation’s fall were positive, and headline inflation fell rapidly in the months around the turn of the year, as we suspected it would. Then in February and March better-than-expected economic activity and, in Europe, a warmer period than usual for the time of year partially arrested the decline in inflation. This created a short-term headache for central bankers, who had hoped that genuine trends of disinflation were finally appearing. The fear is that inflationary trends throughout the developed world remain sticky, but the truth is that it is still too early to tell.

There are also conflicting dynamics within the broad inflation trend. The costs of commodities, energy and the sorts of goods we bought during the pandemic are falling rapidly, but the cost of services, travel and leisure are all understandably higher, due to ‘revenge spending‘ after the reopening of various economies.

We believe inflationary pressures will continue to subside, but it will not be a linear progression. Inflation will almost certainly stay above the US Federal Reserve’s target of 2% through the whole of this year but will fall to levels a long way below where it was last year. In the UK, inflation will also follow a disinflationary trend, but is likely to stay higher than the rates across the Atlantic. In simple terms, there has been some progress, but hard work is still needed on the inflation front.

Theme 3 – Interest rates

Not yet at the tipping point – outlook for interest rates

Last year we talked about the arrival of a tipping point when central bankers stopped obsessing about inflation and were forced to focus on the growth outlooks for their respective economies.

According to the adage, interest rates rise until something breaks. After the banking turmoil experienced among regional US banks, and the tragicomic situation around Credit Suisse, many of our clients have been asking whether there will be another great financial crisis. A natural extension of that question is whether this will be the thing that ’breaks‘, forcing central banks to stop raising rates and even move in the opposite direction.

We do not believe we are going to see a full-blown banking crisis, but we recognise that the nerves created over the banks in the last few months will lead to lower confidence and a reduction in credit creation, both of which will dampen economic activity. Our view is that the banking issues are contained, and the authorities can mitigate the risks presented by this negative turn of events.

If the spill-over effects from the banking sector’s woes lead to slower economic growth in the months ahead, it is likely that central banks on both sides of the Atlantic are close to or at the end of their hiking cycles. Notably, we do not believe they are close to being willing to cut rates, as markets have recently been implying, particularly while inflation remains above the central banks’ own targets.

Theme 4 – Corporate earnings

What are companies telling us?

We believe the core tenets of our current equity selection views are sensible, based on the evidence we’ve gleaned from global companies. The unveiling of corporate earnings in the first quarter (detailing the experience of companies in the last few months of 2022) confirmed the pressures that companies around the world are facing. We expect to see a similar situation when details of earnings achieved in the early months of 2023 are released in the coming weeks.

Revenues remain strong and growing in a world of high nominal economic growth, but profit margins are struggling under the weight of rising labour costs and elevated input pressures. This trend might not reverse as quickly as some commentators hope, which leads us to be wary of relatively optimistic earnings forecasts from analysts, and the implied valuations based on these expectations.

Theme 5 – Market valuations and investor positioning

Uncertainty rules, so what does this mean for investments?

The natural reaction to a questionable economic, inflation and interest rate outlook is to be suspicious of many investments. Surely, if risks abound in the macroeconomic backdrop, investors should steer clear of riskier investments?

Nothing could be further from the truth. Market wisdom suggests that the best investment decisions are those that feel most difficult to make. At times of market certainty, such as we saw in late 2021, complacency is rife and asset valuations are often expensive. That is not the case today.

Two of the key dynamics we focus on when building our clients’ portfolios are asset valuations and investor sentiment; in simple terms, how much does any investment cost relative to its long-term potential worth, and what is everyone else doing? It’s a bit like buying a house, when the worst time to do so is when prices have risen quickly in a short space of time, but everyone still wants to buy houses.

So where are we today? As far as we can judge from the broad trends, the recent market volatility and the falls in certain asset prices have helped our base case that valuations of many asset markets are at fair levels, while general investor positioning, and sentiment, remain balanced. In a sense it is a Goldilocks scenario, where things are neither too hot nor too cold. This leaves us wanting to pursue a balanced and diversified approach with our investment strategies. This is admittedly a common philosophy for us but is particularly relevant now because of the lingering issues that demand further assessment.

Not all investments are equally valued

If the terms ‘balanced‘ and ’diversified‘ sound dull (something we are not ashamed of) we can find more exciting matters to talk about as we closely examine the asset classes¹ at our disposal. Equity markets are another of the subjects we would presently describe as confusing and contradictory, with a range of valuations, from expensive in the case of the US to cheap when we analyse emerging markets. The UK and Europe represent fair value somewhere in between. Our current policy is to embrace cheaper markets, especially unloved Asian markets, and to reduce our holding in more expensive US equities.

To go one step further, within our strategies we have a significant bias away from US sectors such as technology, where we struggle to rationalise current valuations, although we recognise the continued role the sector will play in the global economy’s development in the coming years. Our relative dislike for the technology sector is mirrored by our continued faith in sectors such as healthcare, infrastructure, and renewable energy, which we feel have an equally important role to play in the decades ahead, but notably have more appropriate valuations in today’s uncertain environment.

Excitement in fixed interest markets … really!

Much has changed across the world, the global economy and financial markets since the last decade, and the 'turbulent twenties' have already been an extraordinarily volatile ride. The consistency enjoyed in the previous decade of low but positive economic growth, inflation and interest rates, accompanied by high asset market returns, has been replaced by talk of recessions, sticky inflation, and a whole new paradigm (by comparison) for interest rates.

Last year was a grim experience for traditional fixed interest² investors and the broad conditions for bond markets were the equivalent of what kryptonite is to Superman (not pleasant, for the uninitiated). We look back on 2022 as a necessary and overdue clearing event for fixed income markets. It has taken us out of a rare situation created by central banks (zero interest rates and very low bond yields) back to the normality of fixed interest markets before the financial crisis.

Not back to the future, but back to the past

Many fixed interest investments are once again compensating investors for the myriad challenges ahead. The ripple effects from the banking sector across credit markets³ in March have meant that yields have risen, as prices have fallen, while spreads⁴ (additional yield compensation from investing in corporate bonds over government bonds) have widened. If our base case of slow growth, subsiding inflation and peaking interest rates is correct, it could be a positive backdrop for many fixed income investments, leading us to hold a constructive view on parts of this asset class.

Learn more about why now could be a great time to invest in fixed income

We remain sceptical of holding too much interest rate risk⁵, as one of the great challenges faced by markets later this year will be the deluge of government bond issuance needed to fund cash-strapped governments, in an era of slowing tax revenues. We question what negative impact that will have on market interest rates, and we are also being highly selective in our investments. We recognise that in a slower economic environment, with access to cheap credit likely to be restricted in the wake of some banks’ recent problems, corporate insolvencies and defaults will rise from today’s exceptionally low levels.

Conclusions

So, what does this mean for investors?

We hoped that by this time we would have a clearer line of sight over the investment landscape, and that some of the questions we were pondering at the end of 2022 would be definitively answered. We should have remembered that the pursuit of certainty is an impossibility in financial markets and, as Voltaire magnificently wrote, “Uncertainty is an uncomfortable position, but certainty is an absurd one.”

It is difficult to predict precisely how the economy will fare, whether inflation will settle or what central bankers might do. We believe that our base case of very low growth, subsiding inflation and interest rates on hold is sensible – but operating with an open mind will be vital.

We have more trust in our views on asset markets. As we hope we have conveyed in this edition of Investment Outlook, a whole range of attractive investment opportunities across the fixed interest and equity universes offer attractive future returns. When blended with certain alternative investments⁶, these inspire optimism about the years ahead. The start of 2023 has again shown how unpredictable the world has become in the last few years, but also that all is not lost in the investment world, thanks to the positive progress of most asset markets. While we expect volatility to persist, we remain confident in our ability to achieve our clients’ aims and aspirations in the coming years.

If you have any questions about the current environment or about your investments, please get in touch with us or email questions@canaccord.com.

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• Fixed income investing explained

Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.

The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.

This is not a recommendation to invest or disinvest in any of the companies, themes or sectors mentioned. They are included for illustrative purposes only.

The information contained herein is based on materials and sources deemed to be reliable; however, Canaccord Genuity Wealth Management makes no representation or warranty, either express or implied, to the accuracy, completeness or reliability of this information. Canaccord is not liable for the content and accuracy of the opinions and information provided by external contributors. All stated opinions and estimates in this article are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information.