Client Update - 27th January 2023
It is fair to say that the economics profession did not prove to be very good at forecasting inflation in 2021 – other than that it might go up. As such, any speculation that it will come down again quickly should carry the usual health warnings. However, disinflation is underway. In the US, both headline and core consumer price inflation peaked (in terms of year-on-year changes) in June and September respectively. In the Eurozone the peak looks to have come later, in October for the headline consumer price rate, with the core rate still rising as of December 2022. Consensus forecasts for inflation for most major economies, and a range of emerging markets for 2023, are for declines.
Typically, markets do better when the headline inflation rate is falling. This is already clear from market performance since October last year as things have gradually improved. Further declines in inflation rates in the months ahead should be a positive driver of returns in both bonds and equities. The implications for interest rates are clear, which should boost bond performance. For equities, more price stability should allow greater clarity on costs and profits which should in turn allow more confidence in earnings forecasts and we have seen better earnings reports this week. Regimes where the year-on-year rate of inflation has been falling are associated with the strongest equity returns in recent decades.
The early months of 2023 will be telling. The first half of the year tends to see the highest monthly increases in prices as wages and prices are increased. Given the amount of industrial action currently plaguing Europe there are some upside risks. Similarly, the re-opening of China might contribute to higher global energy and commodity prices, re-invigorating upstream costs for global companies. Yet the trend towards lower inflation should dominate and that is what will be important for market performance.
China’s re-opening is a compelling story, but not without risk. China accounts for between 15% and 20% of global GDP so a doubling of its growth rate this year – not impossible given the experience of western economies coming out of the pandemic – could significantly add to global economic growth. More importantly there will be indirect multiplier effects as China increases demand for goods and services imports. This is already a theme behind the outperformance of European equities in recent weeks. Both global and local Asian investors are likely to increase their exposure to Chinese equities, providing further support for the rally.
Another theme we are thinking about is the potential for an acceleration of investment spending in the energy transition. In the US this is linked to the Joe Biden administration’s Inflation Reduction Act (unfortunately referred to as the IRA) which will provide subsidies up to $465bn for investment in renewable energy, electronic vehicles, semi-conductors and other technologies. It also specifies that a lot of the content must be US produced. The politics of the Act are seen as protectionist and anti-globalisation but the spending it could unleash is likely to be a significant multi-year theme for US businesses.
Equities have potential for more rapid and pronounced bounce-backs. China is an obvious tactical play given the pent-up spending power among consumers and businesses, and the underweight nature of investors. There are long-term concerns about demographics, COVID, China’s technological development being restricted by US sanctions and over the approach to Taiwan but these are unlikely to stop strong near-term gains in the Chinese equity markets.
The big call is on US growth. Investors appear to be underweight US equities, especially big-cap technology stocks. There has been a constant news flow from ‘FANGS’-type companies about staff reductions in recent months. Valuations have come down a lot and, in some growth and value equity benchmark indices, certain big-cap tech stocks have been kicked out of the growth universe. At the same time, disinflation and lower real yields are positive for growth stocks. So might be demographics. Tight labour markets in the post-pandemic world and generally more expensive labour, together with constant innovation in areas like artificial intelligence, should boost the long-term outlook for parts of the technology sector. I would expect companies which can demonstrate steady earnings growth this year, in a world where sales growth is harder to come by, will be rewarded by higher stock prices. Currently we still favour consumer staples, healthcare, and IT sectors, globally, that will likely offer the best prospect of stable long-term earnings growth – and currently their earnings forecasts, at a global level, have proved to be the most resilient.
The consensus is that slower growth and lower inflation means there will be cuts in rates to look forward to. That is not for now though. First, we need to see disinflation, the reversal of real yields and investors responding to some of the key medium-term growth themes which are starting to emerge. We certainly feel our portfolios are well positioned. Do have a good weekend.