Strategy blog: Happier new year?
Few will mourn 2022. Russia's attack on Ukraine; a refresher on Mutual Assured Destruction; assorted political dysfunction – and a material fall in living standards and wealth for most people, as inflation and rising interest rates took their toll on real incomes and capital markets.
We are often able to see "across the valley" quite quickly, but not in 2022.
The conventional asset that has done the least bad job of preserving wealth is cash – ironic, given the inflationary backdrop, though not surprising once the scale of the challenges became clear – and even at year end we find ourselves still advocating portfolios that are more liquid than usual. But as we suggest in Market Perspective, it feels as if the economic mists at least are starting to clear: the key investment call for 2023 may be the decision to put that liquidity back to work.
The economic mists are clearing because it looks as if inflation risk is likely peaking, that it will subside markedly in 2023, and that it can do so without an economic slump (that is, an unusually-large downturn). In this context, there are two key questions we'll be asking as we look to make that call.
Firstly, is enough interest rate risk priced in? We're thinking here not just about the likely highs, but about what is expected to happen afterwards: will rates quickly start to come back down, or will they trace more of a plateau? Secondly, have expected corporate earnings fallen far enough?
Currently, the peak rates priced into money markets look plausible. In the US, a market-implied peak in 2023 of 4.9% (the Fed's policy rate is at 4.5% today) looks a little low (by maybe 50bp?) given recent Fed comments, but eurozone, UK and Swiss highs in 2023 of 3.4%, 4.7% and 1.9% respectively (policy rates at 2.0%, 3.5% and 1% today) seem in the right ballpark. We do however think that in the case of US rates in particular, the likely profile should be more of a plateau than the market currently projects: we doubt rates will start to fall until 2024.
As we've noted, these are "old normal" levels: normalisation is here. Central banks were slow to wake up to the inflation threat, but they have moved quickly to try to catch up in 2022, and the distance left to travel is small relative to the distance now covered.
Earnings expectations have already fallen (see Victor's post last week), but with economic indicators still slowing it is hard to believe they have bottomed out just yet. We almost certainly don't need to see the exact trough, but we do need to feel that the balance of risks is becoming more even – and for that we likely need to see (or to anticipate) stability in the forward-looking business surveys.
Of course, the patience we need in answering these two questions will partly depend on what the markets do in the meantime. If they sell off further, and implicitly price-in more rate and earnings risk than we think is warranted, we may not need to wait so long. Vice versa, if they rally.
Geopolitical developments may of course also affect the call, but we are assuming (sadly) that nothing is about to change there – that is, that the war in Ukraine continues but remains contained; and (more importantly, for the wider world) that China remains patient in (re)-claiming Taiwan.
The call will inevitably be a judgemental one: there are no convincing inflation and interest rate models or infallible valuation metrics. And it will likely have to be made when the newspapers are still full of the bad stuff: we never read about recovery before it happens, and often not even afterwards. There were difficulties aplenty in 2022, but pundits still managed to overstate and sensationalise them – which is their job. We read that the guy who called the crash of 2008 – and those of 2005, 2006, 2007, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019, 2020 and 2021 – is bearish about 2023.
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