Financial markets performed positively for a second consecutive month in November, amid rising hopes that the worst of the inflation challenge is now behind us and that central banks will slow the pace of rate rises. Global stocks returned 7.6% for the month, paring its year-to-date losses to 15%. Positive news on US inflation drove continued gains worldwide. The big outlier was the Chinese stock market, which appreciated 28% amid hopes for an eventual relaxation of pandemic restrictions. Although widely expected, investors were encouraged by indications from the Federal Reserve that it would pursue a more nuanced pace of tightening after four consecutive “jumbo” hikes of 75 bps. This shift in rate hike expectations fueled a rally in fixed income markets, leading to a 4.7% return for the Global Aggregate Bond index. The USD went into reverse gear and closed more than 4% lower against the EUR.
Although there are reasons to be more hopeful, we don’t think we are out of the woods yet. Leading economic indicators continue to point to a weak growth backdrop, and the lagged impact of materially tighter monetary policy on the economy is still uncertain. European economies continue to slow, though recent data suggests it is proving more resilient than feared. Leading economic indicators (PMI) remain in contractionary territory, but they have stopped to deteriorate further. Increasing fiscal support and a mild winter have help cushion the slowdown so far, though we still expect the region to experience a mild recession.
While investors have cheered the prospect of easing inflation pressures and less aggressive Fed policy, the near-term outlook for stocks is less bright. Several business surveys (PMI, ISM) and housing market data added to the picture of a slowing US economy. The lagged effect of 400 bps in rate hikes has yet to be felt. The Fed’s Beige Book confirmed that rate hikes are starting to cool demand, including the demand for labor. However, labor markets are still very tight, and inflation could yet prove too durable for the Fed’s liking. The latest equity rally, lower capital market interest rates, the fall in credit spreads and the weaker Dollar have all led to an easing of the financial conditions in the US – which is exactly the opposite of what the Fed wants to achieve and which complicates their task.
The growth slowdown will finally take its toll on corporate earnings. We believe, bottom-up consensus expectations for 5% earnings growth next year are too optimistic and need to be adjusted downwards. From a valuation perspective, it looks like investors are forecasting only a mild recession and are already looking to the subsequent recovery. In a recessionary environment, earnings can easily drop by 10%-20%. Investors will need to be very sure of themselves to be able to look beyond them. Market behavior could easily shift from seeing “bad news as good news” (inflation, rates) to “bad news” being “bad” as they signal that both growth and earnings are deteriorating faster than most expected.
We expect 2023 to be the year in which inflation will recede, central banks will leave their tightening path and economic growth will bottom. At some point, the market will start to anticipate these turning points. However, we think it is too early. Once interest rate cuts and a stabilization of economic growth and corporate profits are in sight, conditions for a more sustainable market recovery will be in place. We stick with an underweight position in stocks and continue to see value in some other pockets of the market, particularly in high grade bonds.
Please find enclosed our last Asset Allocation Update for this year.
We wish you and your loved ones a very happy and healthy 2023!