The bear market rally materialised, but strong US November job market data cooled the markets’ dovish narrative, creating a mixed picture for US inflation, given that the service components remain sticky. The Fed, for its part, slowed the pace of rate hikes, but reiterated that its job is far from over. We believe central banks, including the ECB, will be walking a policy tightrope, as risks of mistakes are high.
On the other hand, we see increasing geopolitical risks in Europe and the US. In EM, the acceleration of reopening in China should result in a rebound sooner than expected, at a time when Europe will still be in recession and the US in a marked slowdown. This highlights a key feature of the 2023 outlook: the strong regional asynchrony in the economic cycles which could result in opportunities for investors.
For markets, this economic backdrop calls for a confirmation of a correction regime at the end of 2022 and in H1 2023, with inflation slowing, but still above normal levels. The correction phase will be driven by the profit recession, which will materialise in particular in H1. Investors should not add risk, but after the recent upside, return to a more cautious stance in equities and be prudent overall.
- From a cross-asset perspective, we are very active in identifying opportunities presented by market discrepancies and asynchronies in monetary policies that will soon materialise as a response to slowing growth and weaker inflation. Now, after the rebound played out as expected, we turned cautious on equities, with a neutral stance in the US and still cautious positioning in Europe. We also trimmed our positive view in credit after participating in the rally, though we remain slightly constructive. We also believe investors should seek protection throught hedges, US Treasuries and gold.
- US equities have been driven by downward movements in core yields recently, rather than any significant improvement in corporate fundamentals. We see downside risks, an asymmetric payoff, and are becoming cautious in the near term, given that current valuations do not reflect earnings risks in case of a recession. We are therefore moving neutral in the US market. In Europe, which is more exposed to a stagflationary shock, the uncertainty surrounding the Ukraine war continues. The lack of a common policy response and inflation pressures led us to further increase our defensive view on Europe. In relative terms, we keep our preference for the US over Europe.
- In government bonds, markets continue to look at inflation and the Fed’s reaction, but we believe that attention will soon turn to growth and recession fears. For the time being, the direction for rates is still up. The Fed has clarified that it now expects the terminal rate to be higher than what was expected in September. How long central bank keeps rates restrictive becomes more important. Slowing economic growth and hints regarding the change in the size of rate hikes call for an active duration stance.
- Credit markets enjoyed the bear market rally, despite the transition towards a higher funding cost environment that could potentially be more painful, particularly for low-rated, excessively leveraged HY issuers. Corporate fundamentals remain strong, but cash holdings have been declining. Companies’ ability to generate cash flows and withstand refinancing pressures could be affected if the economic backdrop deteriorates. This may be aggravated if commercial banks tighten their lending standards, causing liquidity to dry up for corporates when they need to refinance. Overall, in credit, we see relatively better opportunities in US IG over Europe, and we remain cautious in high yield.
- The USD is a key variable to watch in particular to detect opportunities in emerging markets. We believe that the headwinds that have penalised EM bonds in 2022 will gradually fade in 2023, when country-specific drivers will come back into focus. We stay positive on HC debt, and believe that some LC debt is selectively becoming attractive. In general, reopening plans in China will likely be another positive catalyst for EM in 2023. The recent decision by the Chinese government to lift some Covid restrictions supports an earlier rebound for the economy.