By Matthew Haupt
The good news for equities is that financial conditions are likely to get easier in 2023. The bad news is that we need a sharp deterioration in economic conditions and corporate earnings to eventually induce these easier conditions.
Bond markets are pricing a mild-to-deep recession, while stock markets are pricing a soft landing (for the economy, as interest rates rise).
Below we lay out five dominant themes that will drive markets in 2023:
- Falling inflation pausing the interest rate hiking cycle
- Job cuts before rate cuts
- Leading indicators reaching a trough will assist in a bottoming event for equities
- Australia will benefit from a resurgent China
- The global quest for mineral and energy security
1. Falling inflation pausing the interest rate hiking cycle
Monetary policy action is determined based on lagging indicators, leading to a lag in the effects of their policy, often resulting in policy errors.
In 2022, inflation soared above 9% in the US, 11% in the UK and 7% in Australia, and now almost 400 interest rate hikes across the globe later, it appears we have passed the peak.
While inflation is still at an uncomfortable level above central banks’ lagging indicators and inflation targets, they are acknowledging that recent data indicates inflation is falling rapidly, as the chart below shows.
2. But rates won’t cut until there are job cuts
Falling inflation is celebrated as it implies we are nearing the end of the interest rate hike cycle. However, the job market is still running hot in central banks’ view (WAM Leaders holds an opposing view). Until this slows, central banks will likely keep financial conditions tight (through high interest rates).
Current market pricing implies interest rate cuts from November 2023. But rate cuts this year is a consensus view; the debate is around the speed and magnitude of the cuts.
For rates to be cut faster than these lofty expectations, the global economy will need a sudden softening in the labour market. Headline numbers are still strong, but based on previous cycles, the US Federal Reserve will react incredibly quickly should this change.
In previous cycles, central banks have only tolerated one or two months of job losses before adjusting policy. Over the next six months, job-related data will be our most closely watched indicator given that it holds the keys to future rate decisions.
3. Leading indicators reaching a trough will help a bottoming event for equities
As the excitement following a pause in interest rate hikes recedes, the concurrent economic data will worsen and the market narrative will likely turn to how deep the impending downturn will be, in WAM Leaders’ opinion.
As the chart below shows, leading economic indicators are currently painting a gloomy picture, which will spill over to the coincident numbers in the next few months and send corporate earnings expectations lower. But being forward looking, the market will rally when leading indicators appear to have bounced off their lows.
With earnings re-basing (as the market adjusts its earnings expectations) and peak interest rates nigh, WAM Leaders expect mid-2023 will be a bottoming event for equities.
While WAM Leaders expects equity markets to find a floor this year, it won’t be a straightforward path. The range of potential outcomes continues to be wide, and expectations will remain volatile as markets seek clarity around the depth and duration of the impending slowdown that is underway.
Central banks are in a similar position of making decisions with imperfect information, and we could potentially be entering a “Greenspan” era with frequent policy rate adjustments in both directions.
4. Australia to benefit from a resurgent China
A theme for 2023 will be the transition from a synchronised to an unsynchronised world. China and Japan were the two outliers in 2022 when the world reopened and policy tightened.
Japan is currently wrestling with yield-curve control and keeping rates down, which has implications for the yen and broader foreign exchange (FX) markets, with the yen being the third most traded currency globally.
China, meanwhile, has recently abandoned its lockdown strategy, while instructing local governments to speed up spending and relaxing property and developer rules.
With indicators pointing to a recovery, China will experience a very different 2023 to the rest of the world, even considering softening exports. As Australia’s largest trading partner, a resurgent China should shield Australia from the full force of an otherwise global economic slowdown and support the Australian dollar, in WAM Leaders’ view.
5. The global quest for mineral and energy security
Globalisation had been a dominant, deflationary theme for the past two decades. This ended abruptly when the Trump Administration triggered a trade war with China, with ramifications for global supply chains as companies navigated the high tariffs.
Next came COVID-19 lockdowns that exposed countries that were overly reliant upon imports to supply essential goods.
In 2022, the Russian invasion of Ukraine further amplified the issues of energy and food security as large exports from Ukraine briefly halted while Russia continues to play games with Europe’s energy supply.
All these events have culminated in an urgent desire for countries to minimise their vulnerability caused by limited supply of energy, food and minerals, to the extent it is now a security issue being legislated. Australia is richly endowed with natural resources, which now demand a security of supply premium.
Additionally, increasing demand for rare earths and battery minerals outside of China puts Australia in focus yet again.
So, how do we invest in this environment?
In summary, 2023 will be an incredibly challenging year for companies as they navigate a slowing economy. As talk around inflation fades, policy shift to fighting the economic slowdown will be underway.
This is the environment to invest in high quality, yield sensitive, defensive names that will benefit from an eventual easing of financial conditions and are sheltered from the full severity of an economic downturn.
The good news for equity investors is that WAM Leaders expects there will be a bottoming event through the year, which will produce opportunities to invest in sectors that benefit early in the cycle.
However, this subdued economic environment is likely to be a multi-year story, where policy may oscillate as we experience sporadic slowdowns and accelerations.
At present, caution is warranted but markets are working their way through a necessary process. We hope to introduce more cyclical exposure to the WAM Leaders (ASX: WLE) investment portfolio later in the year.