“There are decades where nothing happens, and there are weeks where decades happen”. Vladimir Lenin was not exactly a financial markets commentator, but his famous quote perfectly applies to almost every week of 2023 so far. It’s been a bumpy ride. January started with a rally across all asset classes, fueled by hopes of declining inflation. Alas, hopes didn’t survive the strong economic data and hawkish comments from central bankers in February, and all asset classes sold-off. In March, stress in the banking sector added a layer of complexity: the initial reaction from markets was negative, but then, as authorities stepped in, including liquidity from central banks, another rally took place, lifting Q1 returns firmly in the green. As we write, investor fatigue after such a wild quarter is palpable in April: so far, most asset classes are broadly unchanged, and volatility has abated.
Is it the calm before another storm, or just a pause in a constructive year of recovery after a horrible 2022?
Before we share our views, we will remind you the title of our 2023 Global Investment Outlook: “Adapting to Unpredictability”. Like it or not (we don’t) unpredictability is real, and it won’t disappear anytime soon. It’s always good to have a scenario, but nowadays, the relevance of any prediction is more questionable than ever. When reflecting a scenario into a portfolio, this lower level of confidence has to be kept in mind.
Let’s start with the scenario, nevertheless. One certainty is that despite warnings from everywhere, including the IMF, the global economy is doing better than expected so far. China is booming, combining reopening dynamics with government support, some stabilization in housing prices, and robust global demand for their exports. But the West is also very resilient: Europe is defying recession predictions, and the US continues to deliver close to 2% growth. Importantly, the latest monthly data does not show a material deterioration in the momentum. Activity should materially decelerate, but the current picture leaves open the possibility of a benign growth outlook for the rest of the year. It’s good. But in an Orwellian logic, good is bad. Resilient growth means potentially persistent inflation, way above targets, especially with strong job market and services. What matters the most for markets is clearly the action from central banks. This is where bad news for the financial system may, in another Orwellian logic, help again: less credit supply from stressed banks has the same impact as interest rate hikes, while central banks are also keen to provide liquidity to prevent contagion. They are not market friendly yet, but they are less adverse. Putting all together, the backdrop of 2023 is not so bad: the West should decelerate but could avoid a serious recession, inflation should soften, while central banks are closer to their most awaited pause in hikes. Meanwhile in the East, Asian emerging countries should continue to grow at much higher levels, with more friendly fiscal and monetary authorities. The path is narrow, but the landing could be soft. But don’t get me wrong: the level of confidence in such a scenario is, again, not tremendous, and the downside risk on Western economies is significant.
From a scenario to a portfolio, the next step is to see what markets already price-in. It gets complicated. Future markets on Fed funds are expecting outright cuts in interest rates later this year. It may happen. Or not: the Fed is data driven and no one has been able to correctly predict inflation for some time (decades, actually). It may also happen because the economy deteriorates much faster, and deeper, than expected. This would be good for safe bonds, but not for Western stocks. At 18 times 2023 earnings, US equities in particular look priced for perfection: resilient growth and rate cuts. There could be some contraction here. We are not in the “doom and gloom” camp, but this doesn’t leave much upside potential and creates vulnerability to any adverse event. It’s not as if we had a shortage of potential concerns, from the US federal debt ceiling to geopolitics. Valuations look more compelling for stocks from emerging markets, but at the price of higher volatility, and sensitivity to global flows - which will also be a function of global risk appetite. Finally, we feel that the excess returns of riskiest bonds compared to the safest ones do not pay for the underlying risks, especially at a time when banks are not willing to lend abundantly, and as higher interest rates push “zombie companies” in bankruptcy.
Finally, our recommended positioning takes unpredictability into account. Investment management is unfortunately not about being always right. It’s about net results: more value from good decisions than losses from bad ones. We seek asymmetry, especially as we expect spikes of volatility ahead. To that extent, one asset class is king: cash. It does not only protect capital and provides flexibility for future moves, but also very appreciable yields. We underweight hedge funds and the riskiest segments of fixed income. We are neutral on equity – which illustrates our current perplexity. We have a clear preference there for emerging markets over their developed peers, for simple fundamental reasons: faster growth, lower valuations. It hasn’t delivered much so far – surprisingly, despite positive surprises on China’s growth. We are not impatient, especially if the returns of our diversified portfolios are good in absolute and outperforming competition. It’s not easy to be patient, as we all know. But it may be the single most important virtue nowadays - and the good news is that after years of zero return on cash, time is now on investors’ side. We’ll be patient, but not sleepy: be ready to seize the opportunities from the next volatility spike.