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High-low silver lining

  • 20 January 2023 (5 min read)

There are several themes which could support better market returns going forward. Concerns that bond returns could be positive when central banks are still raising rates have given way to questions about what parts of the fixed income market are the most attractive. Meanwhile, the limited amount of fourth quarter (Q4) US company earnings reports has not produced enough to change the consensus view that 2023 earnings per share will come in around $225 for the S&P 500 universe. The robustness of those forecasts is the main threat to equity markets. Yet I detect a little more confidence with investors who can focus on themes other than war, raging energy prices, tightening monetary conditions and multiple contractions. There are different things to consider as markets probably trade between the highs and the lows of 2022.

Four themes to think about

There are four themes which I think investors can get their teeth into this year. The first is disinflation which will reduce the need for additional increases in interest rates beyond what is already priced in i.e., 5% for the US Federal Reserve’s fed funds rate; 3.25% to 3.5% for the European Central Bank’s deposit rate; and 4.5% for the Bank of England’s bank rate. The second is the scope for some reversal in the increase in real bond yields that occurred last year. Lower real yields would be positive for bond returns but also for how equity earnings are discounted, boosting the prospects for quality growth equities. The third is the re-opening of China which has already led the consensus view to be underweight US equities and overweight China (and Europe as a beneficiary of increased Chinese demand). The fourth is the potential for increase infrastructure spending in the US.

Inflation coming down

The economics profession did not prove to be very good at forecasting inflation in 2021 beyond that it might go up. As such, any speculation that it will come down again carries the usual health warnings. However, disinflation is underway. In the US, both headline and core consumer price inflation peaked (in terms of year-on-year changes) in June and September respectively. Producer price inflation peaked even earlier, in March of last year. In the Eurozone, the peak looks to have come later, in October for the headline consumer price rate with the core rate still rising as of December 2022. Consensus forecasts for inflation for most major economies and a range of emerging markets for 2023 are for declines relative to 2022’s average inflation rates. 

Typically, markets do better when the headline inflation rate is falling. This is already clear from market performance since October last year. Further declines in inflation rates in the months ahead should be a positive driver of returns in both bonds and equities. The implications for interest rates are clear, which should boost bond performance. For equities, more price stability should allow greater clarity on costs and profits which should in turn allow more confidence in earnings forecasts. Regimes where the year-on-year rate of inflation has been falling are associated with the strongest equity returns in recent decades. The nirvana, which is probably beyond reach for now, is a return of inflation to the pre-COVID-19 norm of close to 2%.

Q1 is a risk to the disinflation view

The early months of 2023 will be telling. The first half of the year tends to see the highest monthly increases in prices as wages and prices are increased. Given the amount of industrial action currently plaguing Europe there are some upside risks. Similarly, the re-opening of China might contribute to higher global energy and commodity prices, re-invigorating upstream costs for global companies. Yet the trend towards lower inflation should dominate and that is what will be important for market performance.

Real lower?

Real yields rose last year, reflecting the tightening of monetary policy and the near end of central banks’ bond buying. Will they reverse? They haven’t yet, especially in the US where the 10-year real yield (taken from the inflation-linked bond market) is still at 1.3%. Real yields are lower in Europe, at 0% in Germany and France and around 0.15% for the UK 10-year part of the inflation-linked bond curve. In the US, real yields tend to rise when the Fed is tightening monetary policy and fall when the central bank reverses. This was the case in 2001-2002, 2009-2010 and 2019-2020. Unless there is a huge increase in concerns about the US fiscal situation, there is no reason to expect real yields not to fall again when the Fed signals that it is not tightening any further.

Lower for growth

I am sure many of you will have seen charts showing the relationship between real yields and the Growth versus Value relationship in the US stock market. As real yields rise, value tends to outperform (as it did in 2022). Lower real yields reflect a reduction in the discount rate for future earnings which has an outsized impact on those long-duration stocks which have solid long-term earnings expectations. US real yields have not moved down enough yet to reverse the outperformance of value versus growth but – at least in the first part of January – growth has started to come back.

China open

China’s re-opening is both an equity and bond story. China accounts for between 15% and 20% of global GDP so a doubling of its growth rate this year – not impossible given the experience of western economies coming out of the pandemic – could significantly add to global economic growth. More importantly there will be indirect multiplier effects as China increases demand for goods and services imports. This is already a theme behind the outperformance of European equities in recent weeks. Both global and local Asian investors are likely to increase their exposure to Chinese equities, providing further support for the rally. On the fixed income side, Asian credit has already benefitted from more optimism around the Chinese growth outlook and the property sector’s stabilisation. With investment grade Asian US dollar-denominated bonds yielding in the 5%-to-6% range global credit and emerging market bond investors are also likely to up their allocation to the region.  


The fourth big theme is the potential for an acceleration of investment spending in the energy transition. In the US this is linked to the Joe Biden administration’s Inflation Reduction Act which will provide subsidies up to $465bn for investment in renewable energy, electronic vehicles, semi-conductors and other technologies. It also specifies that a lot of the content must be US produced. The politics of the Act are seen as protectionist and anti-globalisation but the spending it could unleash is likely to be a significant multi-year theme for US businesses. In the rest of the world, governments are also likely to play a similarly interventionist role to address the need to meet CO2 emission targets and respond to heightened concerns about security in energy and technology. Global supply chains in many of these areas are sufficiently complex to suggest that companies operating in several markets will benefit, despite the temptation to favour local producers. It’s interesting that over the last three months, the sectors leading the recovery in the S&P 500 have been industrials and materials.

What goes down….

Markets have moved a lot since the lows of last October. There is some element of symmetry between the high-to-low moves in 2022 and the subsequent recoveries. In fact, some asset classes have recovered almost all their 2022 losses, largely because the losses were not that big. These include short-duration fixed income assets (leveraged loans and short-duration US high yield) and defensive equities (FTSE 100 and Euro Stoxx). The asset classes which endured the steepest falls in 2023, but have significant recovery potential, include long-duration fixed income assets and growth equities. The S&P Growth index, for example, has only recovered 10% of the drawdown it suffered between December 2021 and October 2022. Asset classes that have recovered by less than 25% include the Nasdaq, German bunds and global convertible bonds. There is a much bigger set that has seen a recovery of less than 50% including European, sterling and US investment grade bonds, emerging market fixed income and most of the broad developed and emerging equity markets.

I am not suggesting all the losses of last year will be fully recovered by all asset classes. One thing for sure is that we are in a higher interest rate environment for some time yet, so that will limit how quickly some bond asset classes can recover – total return indices will get there eventually but more through the compounding of coupon income rather than big capital gains. The same goes for some equity strategies especially if the recessions that are in consensus economic forecasts do materialise and severely impact corporate profits. Yet combining some of the investment themes discussed above with the potential recoveries relative to the 2022 sell-off does provide interesting investment ideas.

Stocks with upside in the next phase of the cycle

Equities have potential for more rapid and pronounced bounce-backs. China is an obvious tactical play given the pent-up spending power among consumers and businesses, and the underweight nature of investors. There are long-term concerns about demographics, China’s technological development being restricted by US sanctions and over the approach to Taiwan but these are unlikely to stop strong near-term gains in the Chinese equity markets. Asian credit is another obvious beneficiary with macroeconomic drivers turning more positive in a market that is cheap relative to US and European credit.

The big call is on US growth. Investors appear to be underweight US equities, especially big-cap technology stocks. There has been a constant news flow from ‘FANGS’-type companies about staff reductions in recent months. Valuations have come down a lot and, in some growth and value equity benchmark indices, certain big-cap tech stocks have been kicked out of the growth universe. At the same time, disinflation and lower real yields are positive for growth stocks. So might be demographics. Tight labour markets in the post-pandemic world and generally more expensive labour, together with constant innovation in areas like artificial intelligence, should boost the long-term outlook for parts of the technology sector. I would expect companies which can demonstrate steady earnings growth this year, in a world where sales growth is harder to come by, will be rewarded by higher stock prices. Companies in the consumer staples, healthcare, and IT sectors, globally, likely offer the best prospect of stable long-term earnings growth – and currently their earnings forecasts, at a global level, have proved to be the most resilient.  

Central banks ahead

In the short-term the market rally is likely to consolidate, and we could see some weakness in the next couple of weeks with Chinese New Year and key central bank meetings coming up. Central bank officials have engaged in the usual pre-meeting warnings about the need to keep increasing interest rates. Of course, they do so because they have not reached the levels the market has been expecting them to get to. Relative to market expectations, the Fed needs to raise rates another 50 basis points (bp), the ECB another 125 to 150bp and the Bank of England another 75 to 100bp. I am not sure the ritual hawkishness is anything new in that regard. The next battle of wills between the market and the central banks will be over the extent to which rates stay at their peak and what the next move will be after enough time is spent there. The consensus is that slower growth and lower inflation means there will be cuts in rates to look forward to. That is not for now though. First, we need to see disinflation, the reversal of real yields and investors responding to some of the key medium-term growth themes which are starting to emerge.

On the up

At the beginning of the 2022-2023 football season, if you had said Manchester United would be third in the premier league, still involved in four competitions and had just come from behind to beat City, I would have struggled to believe it. Yet that is where we are and United are in the mix for the title. Manager Erik ten Hag has done a great job re-shaping the squad and changing the attitude and the results are coming in. The future looks brighter and even more so if the club is sold to a purchaser that is not intent of taking out a massive dividend every year. United remains the only team to have beaten Arsenal in the league this season, let’s see if Sunday brings a double.


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