Markets have seen some relief in a year that overall is likely to be remembered as among the most challenging for investors. But the negative trend reverted somewhat with gains for the S&P 500 and select Treasury Indices. This recent market move has been supported by an alignment of stars on various fronts: (1) US inflation on a downward path, wherein we believe the market rally and the exuberance is excessive, as the Fed will remain focused on the inflation target and it is too early to claim victory there; (2) the earnings season was bad but not as bad as feared; (3) China’s Covid policy relaxation, which has happened earlier than expected, but full reopening will be in 2024; and (4) geopolitical uncertainty, with regard to which there has been some pause after elections – in the US, the mid-terms saw no major surprises and were quickly digested by the market, which reacted well to a divided government that should deter populist policies. Internationally, we can expect more on the US/China tensions front. In the UK, the new PM is changing the fiscal policy stance, with the focus now on tax increases and spending cuts.
These developments lead us to keep an overall cautious view entering 2023, but to tactically play some short-term opportunities within an overall well-diversified approach. In detail:
- From a cross-asset perspective, we have in recent weeks moved towards neutrality in equities. In particular, we have reduced our negative stance in European equities while remaining overall cautious with hedges in place. We have balanced this move by increasing sources of diversification, adding a positive view on oil and gold, and slightly increasing our duration stance on US Treasuries (UST). We remain ready to adjust this stance, as we recognise that the economic outlook is highly uncertain.
- The “bonds are back” theme was supported by the soft inflation reading that led to one of the strongest one-day rallies in Treasury history. However, an active duration stance remains key. Markets are interpreting any indication of lower-than-expected price rises turning into a potential dovish stance by the Fed, which, instead, is likely to wait for inflation to come in below expectations for some time before pivoting. Thus, we remain very active on duration, with currently a positive view through USTs and a keen eye on inflation and growth numbers. US inflation also reverberated in European core yields, where we maintain a close to neutral view, looking out for opportunities across curves.
- The “bonds are back” theme is playing out also in the credit market, with the focus staying on quality. Credit spreads have tightened since mid-October in the US and more so in Europe. However, we remain cautious on risky, low-quality debt of companies, which show a tendency to increase leverage. While corporate defaults are stable at this stage and strong company fundamentals are creating an improvement in credit ratings, it is important to note that ratings and defaults lag economic cycles. Thus, we do not see any convincing reasons to increase risks. Already, corporate cash levels, though still robust, are falling, and this is especially the case for low-rated issuers that would have difficulty raising capital during times when they need it most. Hence, companies’ refinancing needs, their capacity to meet capital needs internally, and CB stances are crucial factors to watch before we alter our stance. At a regional level, though, we continue to prefer the US to Europe.
- Our stance on EM LC debt remains a bit cautious, but we see value in HC debt of select countries. We think the opportunity to increase risks in EM debt hasn’t come yet, as the Fed’s dovish pivot – a key factor for the EM debt outlook – still looks elusive. Having said that, early 2023 could provide some entry points. Regarding China, we expect a gradual reopening in 2023, and the pace will impact growth. In Latin America, we are cautiously optimistic on Brazil, which has been a strong performer in EM this year. But, we are closely following how Lula’s policies affect the country’s financial position.
- In equities, we are tactically trying to capture opportunities while keeping a focus on bottom-up selection. We see the current move as a bear market rally. To assess it as a cyclical bottom for equities, we would need to see improvement in earnings and a Fed dovish tilt, but we are not there yet. In our view, US earnings expectations for next year are still high, given the dual effect of a growth slowdown and the still-strengthening dollar. In Europe, the situation is equally tricky, as some positive signs are emerging, but we need to see some progress on corporate margins and consumption before we are convinced that we are out of the woods. As a result, we stay vigilant in Europe and the US as we explore opportunities in value, quality, dividends, and the small-cap space, particularly in the US. Chinese stocks are highly volatile currently, relying heavily on news flow on zero-Covid policies and economic reopening despite attractive valuations. So, we keep a neutral stance and stay ready to re-enter when earnings fundamentals and economic growth are easier to evaluate.