Our assessment of the trading environment
When will monetary tightening come to an end? It’s the $64,000 question. But we believe it’s likely to happen around the end of 1Q 2023.
Several global central banks—including the Bank of England, Bank of Canada, and the European Central Bank—have signaled that they’re looking beyond current inflation data and shifting their attention toward a more holistic view of the economy. This change in narrative suggests that a slowing pace of interest-rate increases and a subsequent pause are likely. Others, notably the U.S. Federal Reserve (Fed), are resolutely not in that camp, but we expect that changing economic conditions and a more modest inflation profile in the first quarter of 2023 will trigger a shift in their policy stance during the first half of next year.
Unfortunately, the flip side of that coin is that it looks like most developed-market (DM) economies could slide into recession between now and next June. Tighter monetary conditions have already had a noticeable impact on interest-rate-sensitive areas such as housing and durable goods consumption. Similarly, various leading economic surveys strongly imply that the pace of industrial production is set to slow further. In our view, even government spending—usually a stabilizing factor during periods of weaker growth—is unlikely to help the economy. That said, given the massive fiscal stimulus that was introduced during the pandemic, government capacity to increase spending is limited.
Inflation: still the lynchpin for all forecasting efforts
Inflation remains the single most important variable affecting the economic outlook. In a nutshell, the longer inflationary pressures linger, the less scope central banks will have to moderate or, indeed, reverse their tightening cycles. Given the already aggressive removal of policy accommodation, this scenario will only serve to heighten risks to the financial markets and the economy more generally.
Our base case remains that inflation will have to unwind to the point that most central banks will be able to pause and assess the impact of—to borrow a phrase from the Fed—cumulative tightening before the end of 2Q 2023. There’s ample evidence to support this view: Easing supply chains, weaker demand for goods, and the base effects arising from the invasion of Ukraine by Russia are all likely to be contributing factors. There remains, however, an important caveat: Inflationary pressure is likely to ease in an uneven manner. Specifically, key services, including the cost of shelter, are likely to stay persistently high even as other costs fall. The hope is that the disinflationary impulse from goods is able to cool aggregate figures sufficiently to justify a pause in tightening.
If more manageable inflation fails to materialize, central banks will then be faced with two options: choose to look through inflation (as some have already started to do) or continue tightening beyond what markets have priced in. The second scenario will likely lead to yet another bout of increased market volatility.
Foreign exchange: an important consideration in returns over the next year
Looking ahead to 2023, we expect movements in foreign exchange to be an important driver of returns. At present, the U.S. dollar (USD) is the beneficiary of strong U.S. Treasury yield differentials as the Fed’s recent bout of policy tightening has made U.S. bonds a more attractive proposition relative to other sovereign debt. Meanwhile, global uncertainty has likely created a flight-to-safety dynamic that looks set to continue to support the USD. Over the course of the next 12 to 15 months, we believe that any stabilization or reversal in relative monetary policy stances will be reflected in exchange rates, potentially adding an important dimension to consider when allocating to non-U.S. equities.
Our views on equities
As confidence around an end to policy tightening increases, U.S. equities should experience a rally. Stock valuations are also fairly priced relative to historical levels and could provide an attractive tactical entry point; conversely, deteriorating economic conditions and the likelihood of a recession—not to mention its associated impact on earnings—could be headwinds to returns. On a structural basis, we believe the United States has the healthiest long-term economic profile in the developed world, although relative valuation can potentially dent the appeal of U.S. equities. In addition, given the USD’s strength, exchange rates could be a headwind on both a tactical and structural basis, particularly against other key DM currencies as policy normalizes.
A deteriorating macroeconomic backdrop with clear downside risks related to the real estate sector and the highly levered consumer is a headwind to the asset class; a weaker earnings profile is also a contributing factor to our neutral stance on Canadian equities from a tactical perspective. That said, although Canada has a more modest long-term growth profile than the United States, we continue to find Canadian equities attractive in the longer term because of their supportive dividend profile and reasonable valuations. From a currency perspective, an appreciating Canadian dollar (CAD) could provide attractive longer-term support to the asset class.
There are clear headwinds to the region going into a winter marked by energy shortages as Russia’s invasion of Ukraine drags on. That said, stock valuation in the region is compelling, and we’re paying close attention to macro factors. In our view, the removal of any material risks to the region could drive a swift rerating higher, which will likely be compounded by an appreciating euro. Looking past the uncertainty of this winter, the longer-term view for European equities is positive as valuations, the asset class’s dividend profile, and a likely tailwind from foreign exchange rate movements enhance their appeal, not to mention any geopolitical development that could lead to a resolution of the ongoing conflict. It’s also worth noting that the region’s growth profile has improved relative to prior periods.
This asset class is levered to the manufacturing and global trade impulse, which remains constrained by supply chain disruptions and is likely to face headwinds as a demand for goods slows into 2023. We have a moderately underweight stance on emerging-market (EM) equities over the shorter term. Ongoing economic uncertainty in China, which represents a large part of the EM universe, is also a concern. We maintain that EM equities are appealing from a strategic perspective: The asset class’s growth and dividend profiles are attractive over our five-year forecast period. A structurally weaker USD would also provide a modest tailwind to this asset class.
Japanese equities should, in theory, provide an opportunity to investors: Any reversal of the yen’s breathtaking depreciation and continued monetary and fiscal support could provide upside to the asset class. We believe investors should be on the lookout for any evidence that these factors have begun to drive performance. Structural factors in favor of Japanese equities include inexpensive valuation, a possible appreciation in the yen, continued improvement in corporate governance, and generous share buyback programs. Unfortunately, these factors are offset by Japan’s anemic growth profile, leading to a neutral stance in the shorter term, but maintaining a positive bias over a five-year time horizon.
Any sign that Beijing could be taking a step back from reforms that could undermine market sentiment or a relaxation of the country’s zero-COVID policy could lead to a period of outperformance. We’ve long maintained that Chinese growth will need to decelerate to enable the economy to rebalance from an industrial growth model to a more consumption-led model. We also expect the renminbi to depreciate over the next three to five years, and we’re wary of escalating geopolitical tensions—recent U.S. restrictions on microchips being one such example. As such, we remain neutral in the asset class.
Our views on fixed income
The dramatic rerating in the broad fixed-income universe is causing investors to reassess return profiles for most categories in the asset class. Ironically, current yields and historic underperformance are contributing factors for an increasingly attractive return profile. That said, we remain wary of the downside risks associated with this asset class due to the uncertainty around peak policy rates, thereby justifying a modest underweight stance in the short term. Over a longer time horizon, we maintain that the income profile for other income-producing asset classes remains more attractive.
We’re concerned that spreads relative to U.S. Treasuries and credit could widen in the next few months as the economic picture darkens. That said, from a longer-term perspective, we’d perceive any short-term weakness as an attractive entry point into an asset class with a compelling yield profile.
The way we see it, U.S. investment-grade credit is becoming increasingly attractive to investors in light of the asset class’s performance year to date. In addition to sporting an increasingly attractive yield profile, for the first time in years, the prospect of meaningful capital appreciation in the underlying securities has become more tangible. While we believe that U.S. high-yield debt has a more attractive return profile than investment-grade credit, it’s worth noting that the latter can be used as a tool for investors to add duration to their portfolios. In our view, higher-quality credit can be an attractive alternative to investors seeking refuge from current market volatility.
Unlike in the United States, clear signaling from the BoC that increases to the policy rate are winding down augurs well for the asset class, especially given its return profile. Unfortunately, somewhat clouding this view is that Canadian government bond yields are heavily influenced by movements in U.S. Treasuries, which remain somewhat less certain, therefore justifying an underweight stance in the short term. The arguments we used for U.S. fixed income also apply here, albeit with one important exception: An appreciating CAD—which we expect will happen on a structural basis—will mean a slightly more attractive return profile (relative to U.S. Treasuries) for both Canadian sovereign debt and credit, which should take place over a longer-term timeframe.
We expect European and Japanese interest rates to continue to lag relative to the United States. In our view, normalization will inevitably push European and Japanese rates higher, particularly at the longer end, which should translate into headwinds in both bond markets. On a currency-adjusted basis, we find Japanese fixed income slightly more attractive than European fixed income. In the near term, we’ve retained a small underweight stance on both asset classes and have a neutral view on them over the long term.
We remain structurally overweight in EM debt. Over the long term, we think this asset class can provide some of the most attractive expected total returns thanks to the relatively high level of expected income returns it offers. We note, however, that in light of recent market corrections, disparities in income profiles between EM and DM debt have narrowed somewhat, slightly tempering EM debt’s relative return profile. Our expectations for a weaker USD over the longer term are also contributing factors. Shorter term, we think the asset class continues to provide an attractive yield profile; however, possible continued USD strength and cooling growth in developed economies could suppress the global manufacturing impulse. Both of these developments suggest that a slightly cautious stance could be warranted in the short term, but we remain overweight in the asset class over the longer term.
Our views on alternatives/real assets
U.S. real estate offers favorable valuations relative to other DM as economic activity—while moderating—continues to support fundamentals. As mentioned previously, we’re of the view that yields and prospects for dividend growth for the asset class remain attractive even within a moderating economic environment. We’ve retained our neutral stance, however, in light of the bifurcated prospects within the sector’s various segments: While the outlook for industrial, retail, and residential, where valuations are compelling and still recovering from prepandemic levels, remains positive, the same can’t be said for the self-storage, office, and hotel sectors, where demand remains weak relative to supply, largely stemming from the impact of the COVID-19 pandemic.
Although oil prices appear to have settled within a relatively wide range (roughly between US$75–US$95 per barrel), the medium-term balance of risk remains firmly tilted to the upside. Vulnerabilities center on the delicate balance between supply and demand of crude oil, which remains incredibly tight as a result of Russia’s invasion of Ukraine. This is despite mainland China’s commitment to its zero-COVID policy, which has added an element of uncertainty to the market given the country’s historical appetite for oil. Understandably, the current strong USD environment is also influencing the overall supply-demand dynamic. Prices have also been somewhat artificially contained by an extensive drawdown of the United States’ emergency crude stockpile.
In the metals space, the price of copper has remained stable while the price of gold remains firmly in a downtrend. In our view, the price of both metals could slip lower in a world characterized by continued Fed tightening and weak global economic activity. Agricultural commodities remain well supported as a result of geopolitical factors and operational challenges constraining key grain exporters.
Listed infrastructure has become an increasingly interesting asset class that we believe deserves attention from a strategic asset allocation perspective. In our view, the asset class provides an attractive income alternative to what’s been a low-yield environment. In addition, infrastructure improvement is a common policy plan within governments across the globe, which should be positive for returns for years to come. Given recent declines in the asset class valuations, forecast returns for this asset class make it even more compelling.
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