Our last quarterly column here was about 2023 being a year of unpredictability for markets, and perplexity for investors. We had changed our positioning to become a bit more defensive, after a very strong first half of the year. Indeed, the third quarter has been holistically negative, and October, which just ended, is no better: except for short term money markets, up +0.4%, and gold, up 7%, all major asset classes delivered negative monthly returns.
No doubt, the sentiment has turned. Just a few months ago, there was a very strong consensus for an almost perfect “soft-landing” scenario, combining a resilient global economy with a gradual normalization of inflation, allowing central banks to pause before, ultimately, becoming investors’ best friends again.
The message from markets is now different. At almost 5%, the US 10-year Treasury yield is more than a full percentage point higher than at mid-year, and it is true for pretty much all maturities. Higher “risk-free” yields command lower equity multiples: global stocks are down -10% on average from their summer high.
But are these yields really “risk-free”? Between the recent downgrade of US government debt rating by Fitch, the abysmal depth of budget deficits, and the political dissensions in Washington, a growing number of investors are questioning this status and the sustainability of government debts in general. As exacerbated geopolitical tensions are fueling risk aversion, and as bonds are not playing their usual role of safe haven (leaving it to gold), investors are looking at a future threatened by fears of escalation, tight financial conditions with high interest rates and strong dollar, and high energy prices.
No doubt, it’s not difficult to be pessimistic. The BoA fund manager survey shows that fund managers keep a record level of cash on the side, and their bull/bear indicator is at 1.5 on a scale from 0 to 10.
Now, let’s have a cold look at the facts, starting with global growth. It is not bright, it shows divergences, but it is certainly not that bad. The world’s largest economy is becoming even larger: US real GDP grew at a stellar +4.9% annualized rate in the third quarter, which is, in current dollar terms, more than 8% given the level of inflation. Leading indicators for October show some deceleration, especially in manufacturing activities, but no collapse.
By contrast, Europe is weak, flirting with recession: Eurozone GDP contracted in Q3, and PMIs are weak. But Asia is getting better: China is stabilizing, and the recent unexpected announcement of a one trillion yuan fiscal stimulus plan should support growth in 2024. Korea industrial production surprised on the upside with a strong tech impulse, and so did GDP growth in Taiwan in the third quarter– at a very impressive +10% annualized. The big picture for growth is not booming, it shows divergences and downside risk, but it is not terrible.
Inflation remains too elevated for central banks, no doubt. But the trend of prices is encouraging. US core inflation was below 3% annualized in Q3. In Europe, as activity slows, inflation is clearly trending lower. China does not have any inflation issue. Western central banks are not hiking anymore. The Fed kept rates unchanged for the second straight time this week, with hints from the press conference that they may be done. The ECB did the same last week as did the Bank of England on Thursday.
Finally, corporate earnings are overall clearly above expectations in the US, by a wide margin (around +8% against consensus). Europe is less impressive, but earnings are certainly not alarming: they are overall in line with expectations. Japanese exporters are enjoying a weaker yen, and companies from emerging markets are overall dealing very well with the macro environment.
Of course, future earnings will heavily depend on future economic activity, with a wide range of possibilities. But the current market action seems to be a bit too dark, with all asset classes in the red. In case of a global recession, cyclical assets could suffer, but safe bonds should do well, excluding the highly improbable scenario of major countries going bankrupt. Inflation would collapse, central banks would cut rates, and after a correction, stock markets could be on track to recover. Should global growth remain resilient, investors should enjoy the income from bonds, and be more confident in the current equity valuation multiples as earnings would continue to grow. There are only two very adverse scenarios affecting all asset classes, and hopefully their probability is very low: a material reacceleration of inflation, out of control, or a massive geopolitical deterioration.
Unpredictability, the theme of our 2023 Global Investment Outlook, remains the name of the game for the year. We are not saying that there is no shortage of concerns. But in front of them, between resilient growth, a more cautious stance from central banks, better valuations for most asset classes, and investors’ sentiment being clearly bearish, we definitely recommend remaining diversified and patient, with a balance between the income from safe sources and the growth exposure from risk assets. Investing is a long-term game, and pessimism is not always a bad thing.