Shifting Markets

Although weakening along with the rest of the world, America’s economy is still in a healthier place than many developed market equivalents. Both household and company balance sheets look relatively robust, and we think profit margins, although likely to fall, are appealing.

Much of the US market’s performance in 2022 was driven by high interest rates. As rates increased, the future earnings for companies were affected as the cost of borrowing was now higher. This drove investors away from so-called growth stocks (such as the large US tech firms) and into value stocks, which are typically less impacted by interest rates.

These high interest rates aimed to combat high inflation. Now we think US inflation will move more decisively past its peak over the next few months. As a result, the Federal Reserve is likely to be able to slow the pace of interest rate rises and then probably stop hiking them altogether. Therefore, this headwind for US equities is likely behind us and see opportunity in the high-quality nature of the market.

Price pressures are also less entrenched in the US, particularly when compared to the euro area where producer price inflation is much higher, which is another positive sign for US equities.

The large interest rate hikes throughout 2022, coupled with our view that the Federal Reserve will slow rate hikes in 2023, have made US Treasuries attractive to us. They offer a defensive role in portfolios while providing higher yields compared to their history. However, it’s worth noting that these yields can fall if the recession turns out to be more severe than markets expect.

US equity valuations have dropped materially in 2022 but remain elevated. Although this situation leaves US equities relatively expensive compared to other regions, we believe this is the price worth paying for exposure to a high-quality equity market as recessionary pressures rise.

Our analysis show that high-dividend equities have performed well following the peak in interest rates. It’s a similar story for low-volatility equities, which have shown a positive relationship with bond prices historically so should benefit from falling yields.

We think demand for the dollar is still close to extreme levels heading into 2023 because of recession fears. This should diminish over time due to the appeal of US Treasuries and the dollar’s value will likely stabilise at elevated levels. A significant fall in value is unlikely during the first half of 2023 for three reasons:

1. Other central banks slowing interest rate rises in the wake of the US Federal Reserve. 2. Weakening growth prospects both in the US and globally. 3. Limited fundamental strength for other risk currencies.

This stubbornly high inflation across both the euro area and UK is partly driven by past currency weakness and the high costs of energy. While inflation is slowing in the US, we believe that it is moving closer to the peak (probably in Q1 2023) for Europe.

Given that we expect a recession in early 2023, we believe the earnings expectations euro area equities are at risk of being downgraded. Notably, these earnings expectations for the year ahead are 15% higher than they were at the start of 2022.

So far company sales growth has outstripped inflation, which has in turn kept nominal earnings growth in positive territory (as shown in the graph). However, as real growth slows and inflation stays high, we believe many companies across the region will be unable to continue to pass all their costs onto customers. This will put profit margins and earnings under pressure.

We believe that the difference in yields between European/UK investment-grade bonds over US investment-grade bonds are attractive. In fact, they are close to the levels we saw during the worst of the euro area crisis.

High-quality corporate bonds in the euro area also look increasingly attractive as interest rates peak, the pace of economic growth slows, and inflation falls back.

We are still cautious on euro area equities given the risk of earnings surprising to the downside so have a higher weight in US and emerging markets equities.

Unlike many equity markets, we find the earnings and valuation picture depressed for emerging market equities, driven by China. At such depressed levels, and given China’s potential stimulus and reopening, we think the 2023 outlook for developing equities to be more positive than for developed market equities.

One of the major headwinds for emerging market equities in 2022 was the strong dollar. As we move into 2023, we believe the outlook for the dollar is one where it weakens slightly, allowing central banks across emerging markets to stop hiking interest rates.

While the West is raising interest rates to lower inflation, China is cutting interest rates to stimulate growth.

Since half of the emerging market bond index is investment grade, we believe emerging market bonds are more attractively valued compared to US high-yield bonds.

There’s also potential for the headwinds facing emerging market hard currency sovereign bonds to dissipate – including a strong US dollar, virus outbreaks, high food prices and one-off events. This asset class was one of the worst-performing areas of fixed income markets in 2022, so we view their valuations as an attractive entry point.

In equities, emerging market valuations already reflect the significant slowdown in growth – unlike Eurozone earnings which are too optimistic in our opinion given the likelihood of recession. Therefore, we think the outlook for emerging market equities is positive, particularly given China’s possible relaxation on its zero-Covid policies, which should help boost growth in the area.