Summary
1. Economy better than feared? Lower petrol pump prices and resilient employment are supporting consumption. Persistently lower inflation should support consumer demand further in the months ahead. This is reflected in better-than-expected economic activity, and could limit expected corporate profit pressures.
2. Lower energy burden: European natural gas and electricity prices at end-2022 sat 35-40% below their yearly averages. If energy demand can be reduced further without a big impact on output, the energy cost drag on Europe may be lower than predicted. This would support not only a modest recession but also a rebound in the euro.
3. How poor was 2022 for balanced portfolios? The worst year since 1937... Rampant inflation and ultra-low starting bond yields led US long bonds to their worst annual loss in 100 years. With double-digit losses in stocks and real estate weakness, investors had few places to hide.
4.Factors that support our Positive Equities view include a) falling energy prices and inflation rates; b) better-than-expected economic momentum as consumers hold up well; c) a rebound in global liquidity (represented by global M2 money supply), and d) stable to lower long-term real bond yields.
5. Our top 5 conviction ideas for start-2023:
i) Precious metals commodities and producers; ii) European value style and sectors; iii) US investment-grade corporate bonds; iv) subordinated and AT1 contingent financial bonds, and v) the global healthcare sector.
Looking back at 2022
Inflation surprises hurt financial markets
The emergence of unexpectedly strong and durable inflation surprises was the single most important factor driving investment portfolios last year.
The price to pay for a successful post-pandemic economic recovery: governments and central banks together engineered strong economic recoveries following COVID-19 lockdowns via a combination of injecting of money into the economy to encourage spending, and zero or negative interest rates to encourage borrowing.
This proved successful in relaunching the global economy, which posted a strong 5.8% GDP growth rate in 2021 as economies reopened and benefited from these combined boosts from fiscal incentives and ultra-low financing rates.
An inflationary cocktail when mixed with restricted supply: unfortunately, the global economy took longer to re-establish production of goods in COVID-affected Asia in particular. As any economics student will tell you, the first taught principle is supply and demand. More demand than supply, as we saw in 2022, results in higher prices, i.e. high inflation.
Outbreak of the Ukraine conflict compounded inflation difficulties through energy, raw materials shortages: as if this combination of soaring demand and restricted goods supply was not bad enough, inflation received a second massive impulse from the outbreak of the conflict in Ukraine in February 2022.
All about energy: the principal impact on the global economy stemmed from a sudden restriction of supply of crude oil, diesel and natural gas from Russia to Western countries. This was triggered by voluntary cuts in Russian gas pipeline supply together with the imposition of sanctions on Russian oil. Brent crude oil hit nearly USD130/barrel in March, while European natural gas surged to over EUR300/MWh in August. This huge hike in energy costs leaked through into inflation, leading to double-digit peaks in annual inflation rates in the US and Europe.
Inflation surprise plus ultra-low long-term bond yields equals bond market pain: the January 2022 starting point for government bonds was close to historic lows in both the US and Germany. Unsurprisingly then, the surge in inflation triggered a bond market sell-off and resulted in the worst US bond market performance in 100 years at -14%. Ultra-long bonds suffered the most as they are most sensitive to changes in inflation, with the US extended duration bond ETF falling 38% over 2022.
No hiding place in credit, equities or real estate either: the fallout from rising inflation and interest rates hit other asset classes too. Global corporate credit and stocks lost 16% and 18% respectively in US dollars over 2022, while real estate prices cooled too.
Only commodities and macro hedge funds resisted: aside from cash, the only asset classes to post positive performance in US dollars over 2022 were commodities (+16%) and macro hedge funds (+4%).
The Macro Picture
Is everyone too pessimistic about recession?
US inflation continues to cool: the personal consumption expenditures price index (PCE), tracked closely by the Federal Reserve, rose by a below-forecast 0.2% in November. This reflects the ongoing trend of easing US inflation pressures and comforts the argument that higher interest rates are cooling demand and thus also inflation.
Key goods-related components of US inflation have been heading lower, as observed in the sharp falls in the US ISM manufacturing prices paid sub index. This fell from an extremely high 87 reading in March (on a 0 – 100 scale, where 50 is flat) to a contractionary 43 in November.
Added to this are falling rent inflation, lower gasoline prices and lower natural gas prices.
A slightly stronger euro should help bring down European inflation: we are starting to see evidence of this in the lower Spanish, French and German CPI readings in December versus the November peak in eurozone inflation, aided by similar disinflationary supply chain-related factors as in the US. The inflationary hit from energy prices will ease quickly in the months ahead, and a stronger euro will also help to moderate import prices.
How bad can any global recession be? While inflation may be finally cooling, the delayed effects of higher interest rates have continued to hit economic demand into the new year. The delayed effects of higher energy costs are also biting into growth, as companies and household adapt to these more elevated price levels.
Higher rates have a delayed effect on a huge segment of the economy: housing & construction. Lower house prices translate into reduced construction activity, which in turn results in lower employment. How bad will these combined lagged effects be for economic growth in 2023? Are recessions in Europe and the US still on the cards?
Household consumption will determine whether or not we see global recession, and the depth of any regional recessions in Europe and the US. Employment levels remain historically very high and wages continue to rise. To this we can add the support of an abnormally high level of cash savings post pandemic.
If household energy costs continue to decline, there is a good chance that Europe and the US could experience surprisingly short and modest recessions, suggesting a smaller-than-feared hit to corporate profits.
Investment Conclusion
Is the economy is better shape than feared? Lower petrol pump prices and resilient employment are supporting consumption. Persistently lower inflation should fuel consumer demand further in the months ahead. This should then be reflected in better-than-expected economic activity, and could limit expected corporate profit pressures.
Focus: Falling Energy Costs
A lower “tax” on the global economy
Lowest energy prices since February 2022: it is true that current winter weather is relatively mild in Europe at present. Nevertheless, lower household heating demand plus dramatic cuts in industrial energy demand (November 2022 European industrial gas usage was 24% below November 2021’s level) are resulting in a sharp fall in European wholesale natural gas and electricity prices.
Comfortable gas stocks: one outcome of this lower European energy demand is a higher resulting level of natural gas stocks. According to industry group Gas Infrastructure Europe, European gas storage is still 84% full, far above the seasonal 5-year average of 70%. Moreover, Liquefied Natural Gas (LNG) cargo volumes continue to grow as US gas producers are able to ship more gas to Europe, suggesting that Western Europe is increasingly able to replace Russian pipeline gas with US LNG cargoes.
Renewable energy generation picks up: a second contributing factor is the higher electricity generation from wind turbines across Europe on the back of strong winds. This is a sharp reversal of the situation earlier in 2022, when a lack of wind-driven electricity obliged utilities to turn to burning more gas and coal.
Crude oil and oil product prices return to pre-conflict levels: potentially the greatest implicit “tax” on global economic growth is the cost paid by oil-consuming nations for importing crude oil and oil products from OPEC and other oil-producing nations.
This energy burden peaked in mid-2022 when US gasoline prices breached USD5/gallon. But since then, oil prices have steadily fallen, to reach today levels for both crude oil (USD79/barrel for West Texas Intermediate) and US gasoline (averaging c. USD3.20/gallon), well below February 2022’s marks.
Result – rebound in European business confidence: this partial release of energy cost pressure on the European economy is a key factor behind a surprising rebound in business confidence across Europe over Q4 2022. The German IFO business expectations subindex has rebounded from a low of 75 in September to over 83 as of December, while a similar rebound can be seen in Sentix Eurozone economic sentiment indices.
While energy costs continue to rise in the short term for industry and households, this fall in wholesale prices suggests that the worst of the energy impact for the global economy may be already behind us.
Investment Conclusion
Lower energy burden: European natural gas and electricity prices at end-2022 sat 35-40% below their yearly averages. If energy demand can be reduced further without a big impact on output, the energy cost drag on Europe may be lower than predicted. This would support, not only a modest recession, but also a rebound in the euro.
Equities Outlook
Favour eurozone, UK and EM exposure
Factors that support our Positive Equities view include a) falling energy prices and inflation rates; b) better-than-expected economic momentum as consumers hold up well; c) a rebound in global liquidity (represented by global M2 money supply), and d) stable to lower long-term real bond yields. To these we can also add attractive valuation levels (compared to history) in World ex US equities.
Stronger momentum in eurozone, UK and Hong Kong stocks in late 2022: the better earnings resilience of earnings estimates in Europe and the UK, plus the historically cheap valuations still on offer (including high and well-backed dividend yields) are key factors for our preference for European stocks, particularly those with a value bias.
Hong Kong and China are also in focus within our positive Equities view, given the positive Chinese credit impulse and softened zero COVID policy which should both support stronger growth. Again, Chinese stock valuations are attractive, but to this factor we can now add more optimistic economic expectations.
Tilt towards Value style and sectors
Within our positive stance on global stocks, there are a number of clear trends and preferences that we would highlight for investors looking to gradually deploy cash back into stocks after a tough 2022.
Stay the course with Energy: we believe that energy prices have an asymmetrical outlook, a much higher probability that they will rise than fall over time, remaining far above long-term averages. We favour the global Oil & Gas and Renewable Energy sectors.
Cash flow-rich value sectors still favoured: we like portfolios based on the Value style, comprising a heavy bias to strong cash flows and balance sheets, including the Energy, Financials and Mining sectors.
Prefer US equal-weight, mid-caps over benchmark S&P 500: US mid-caps are more domestically-focused than large-caps, a benefit given the strong US dollar, while US domestic consumption remains strong. US mid-caps boast robust balance sheets and trade at a deep 25% P/E discount to the S&P 500 index. Within large-cap exposure, prefer equal-weighted indices to reduce the bias to mega-cap technology stocks.
Investment Conclusion
There are ongoing signs of improved trends in energy costs and inflation, financial conditions, liquidity, and near-term economic momentum. These trends are key factors in our Positive stance on Equities. We maintain a preference for the Value investment style, towards energy sectors, emerging market and UK stocks and to US mid-cap exposure. More conservative investors can focus on quality dividend strategies in view of the generous pay-outs available today, especially from world ex-US stocks.
Bond/Credit Outlook
How much is lower inflation already priced?
Bonds prefer falling inflation: after a historically awful 2022 for fixed income as inflation shot up to double-digits in many developed and developing countries, 2023 should provide a better backdrop of falling inflation rates. US 1-year inflation swaps price US inflation in 1 year at 2.4%, while Euro 1-year inflation swaps suggest 3.2% Euro inflation by the beginning of 2024.
Comparing bond yields with short-term cash rates: at a time when the US Fed Funds benchmark interest rate stands at 4.5%, the UK Bank of England’s base rate at 3.5% and the European Central Bank’s benchmark repo rate at 2%, there is today greater competition for investors’ savings than in previous years.
Absorbing short-term bond issuance is a challenge: in contrast to the last few years, central banks, such as the US Federal Reserve, are no longer buyers of government bonds, but are rather sellers of bonds as they continue to reduce their balance sheets (known as “Quantitative Tightening”).
Domestic investors the key bond buyers: this suggests that domestic investors (insurance and pension funds, retail investors) will have to be the principal buyers of 2023 government bond issuance. Given expensive FX hedging costs and higher Japanese government bond yields, foreign investors are unlikely to be big buyers of US and eurozone government debt in the short term.
A terrible 2022 augurs better for credit in 2023: 2022 was by far the worst year on record for US IG credit returns (over the past 50 years). In total, 11 years out of the past 50 have seen negative IG credit returns, but only 3 worse than -3% prior to 2022. If we look at the 6 previous years where US IG credit returns were -2% or worse, in 5 cases the subsequent year’s corporate bond returns were strong. The only exception was 1979, with a tiny drop again in 1980. This augurs well for US IG credit returns in 2023.
Overall then, we continue to favour investment-grade credit in the US to Treasury bonds, and prefer quality eurozone corporate bonds to high yield.
Investment Conclusion
We reiterate our positive view on IG credit (offering around 5.7% for BBB-rated bonds in the US, and 4.3% in Europe). This view is comforted by the decline in investment-grade credit risk (measured by CDS spreads) the relatively solid balance sheets and the cash flow generation of companies in the IG credit universe. Central banks should end their tightening cycles in early 2023, allowing bonds to rebound.
Focus: Positive on Precious Metals
Gold has protected non USD-investors
Gold has been a positive asset class for euro, sterling, Chinese renminbi and Japanese yen investors. Euro-based investors benefited from an 8% gain in 2022, while sterling and yen investors received 14%-15%.
However, the gold price in US dollars only managed a paltry 1% gain over the year, due to two major factors:
a. the stronger US dollar on the one hand, and
b. higher long-term bond yields on the other.
Why then is gold (and silver and platinum) attractive for investors today? We see four main reasons:
1.The US dollar is now weakening, boosting opposing currencies including financial commodities such as gold;
2.Lower long-term US bond yields and thus lower real yields (after subtracting expected inflation);
3.Real diversification, after a year when bonds have NOT been an effective diversifying asset, and
4.When the claim that bitcoin is a true digital store of value (“digital gold”) has been undermined by its 75% drop from the November 2021 peak.
Central bank gold purchases accelerate
There are two other noteworthy points regarding gold:
1.Central banks were heavy buyers of gold all year long, as Russian, Indian and Chinese central banks looked to hold more reserves in assets and currencies than in the US dollar and US Treasury bonds.
In my view, this trend is likely to continue, as the US dollar becomes less and less attractive to these countries now that the US has effectively "weaponised" the US dollar.
2. Since the beginning of 2000, gold has outperformed other asset classes by a wide margin at +466% (in USD) to date, versus +221% for global stocks, +293% for global listed real estate and +102% for global sovereign bonds and credit.
Ultimately, ongoing geopolitical tensions, robust central bank demand, lower bond yields and a weaker US dollar are all favourable tailwinds for both gold, and by extension other precious metals, such as silver and platinum.
Investment Conclusion
Gold is starting to glitter again, and should be considered as a useful diversification asset for investors' portfolios. Those with a higher risk appetite could also consider exposure to a broad basket of precious metals, including silver and platinum, which in many ways look fundamentally more attractive than gold given the rising demand from energy transition applications (e.g. solar panels, hydrogen power).
Real Estate Outlook
Spotting selective emerging opportunities
Diversified property exposure provides an investment in income-yielding real assets with exposure to rental growth. This is attractive for long-term investment portfolios heavily weighted to financial assets such as stocks and bonds. Commercial property has performed well over the last 20 years: European commercial real estate funds have generated an average total return of 5.7% per year since 2002.
However, in the short term both weak economic growth and higher interest rates are clearly headwinds for commercial property. However, the worst economic effects are already being felt in property prices. Over 2022, listed Real Estate (REITs) returned -25% in the US and -38% in Europe, worse than US and European benchmark stock markets.
This reset in property prices should provide a better 2023 entry point for long-term investors than was available in 2021 or 2022, at higher rental yields.
BNP Paribas Real Estate forecast 5-year European commercial real estate returns in the 4-5% annual range until 2026, well above current interest rates.
Commercial property adjusts faster in Europe
Over Q3 2022, global real estate returns were flat according to MSCI Global, with capital values falling by 1% globally over the quarter, offsetting a 1% income yield. European countries saw a greater adjustment in capital values, led by the UK with a 5% decline in real estate prices over Q3, while Germany saw a 3.5% price decline and France a 3% decline over the same period The best performance regionally came from Central/Eastern Europe and Asia, where real estate prices continued to increase.
While the more challenging economic and financing climate is driving a period of adjustment, this presents opportunities to new real estate investors. The desire of existing unlisted real estate fund investors to sell their units is likely to force these funds to liquidate a number of properties in 2023, generating in turn a number of value opportunities to potential buyers.
According to BNP Paribas Real Estate Investment Management, both Healthcare and Residential rental segments should offer annual rental growth of over 3% per year from 2023 to 2027 on the back of high rental demand in both segments.
Investment Conclusion
It is clear that quoted REITs have seen a much faster mark to market adjustment than in non-listed property funds. For investors already invested in unlisted real estate funds, holding over the long term, throughout the current adjustment period to the recovery beyond is the preferred strategy. For investors with new capital to commit, we see selective opportunities emerging in segments such as Healthcare and in Prime Logistics.
Investment Strategy Focus - January 2023 - PDF