Global Equities
Risk assets have enjoyed rather a good start to 2023 after a year to forget. There is certainly more optimism around as a number of inflation data prints have suggested a cooling in the rate of price increases in the global economy. This in turn means interest rates may not have to rise as much as feared and provides relief to asset valuation multiples, which accounted for most of the equity market falls of last year. This also reduces the likelihood of restrictive policy pushing economies into recession, so it is unsurprising that there has been relief across markets. However, it was always expected that inflation would ease from the highs of last year, as falling energy prices and some of the supply side issues resolved and we fear that some investors are getting ahead of themselves. Central bankers across the globe continue to stress that rates will either have to continue rising or will at least stay at an elevated level for an extended period – the bond market simply does not believe this is the case it seems.
We must also bear in mind we might be in an era of not just higher average inflation but also higher inflation volatility – there will be periods where inflation subsides but, if it coincides with a slowing economy, fiscal and monetary response may simply charge it up again, creating an unwanted cycle. This backdrop makes running money much more difficult as the fundamental outlook keeps shifting. Remember too that when inflation is over 5% it generally takes years for it to normalise to the 2% level. If central banks abandon that (admittedly rather arbitrary) target, it will simply entrench inflation more. We also have structural forces, like deglobalisation and the (expensive) response to climate change, which will create sustained inflationary pressures. Given the rise in debt service costs that come from higher rates, just how much further can policy makers go in their attempts to control inflation at times when it resurfaces?
If the Federal Reserve needs to break the labour market to bring inflation under control, there is likely to be economic pain ahead. In truth, the US economy has been holding up well but unemployment is a lagging indicator and things could get more difficult. Perhaps this is when concerns will grow over earnings expectations, which still look to be too optimistic to us, certainly in the US. At least bond markets should provide more protection for investors this year than last and we have been adding to quality fixed income in small measure. More volatility in inflation will be unhelpful too, of course, but there does look to be reasonable value here as investors realise the ‘there is no alternative’ mantra favouring equities is no longer appropriate – goodbye TINA! The equity risk premium (a measure of the amount of excess return of the equities market over the risk-free rate) is rather low at present and some widening of this premium is probably going to be necessary before a truly sustained run in equities transpires.
We remain hopeful that 2023 will bring opportunities to risk assets, including equities, but think this might be further into the year. The macroeconomic uncertainty is likely to persist for some time and, with equity markets offering better value than a year ago but still not being particularly cheap, patience may well be a virtue for a few quarters yet.
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