Mid-year outlook 2023: investment convictions

Caution in equities is still required while Fed rates plateau. Market performance between when the Fed stops raising rates and the first cut could be positive or negative, depending on economic conditions.

This was positive when there was no recession (1984,1995, and 2018) or when a bubble was building (2006). In our scenario, we see a risk of recession in H2, triggered by a weak earnings seasons in Q2-Q3. As such, we remain on the cautious side for H2.

In March 2003, the correction of the Growth vs. Value overvaluation found another impulse in favour of Value as the market bottomed out.

Repetition is a strong possibility. In the meantime, we favour quality (low leverage, earnings recurrence and protected dividends). However, at a regional level, the United States — usually a quality play — is too expensive and deserves to be underweight entering H2 2023.

DM fixed income investors remain focused on sticky inflation and the need for CB to do more. We expect the Fed to push the US economy into recession to bring inflation closer to 2%. The ECB remains focused on inflation despite disappointing economic data and Germany’s slide into recession. In the Eurozone, growth should remain subdued and inflation sticky. On fixed income markets, in the United States this translates into a slightly positive stance on duration. We see curve steepening opportunities (5-30y). In the Eurozone, investors should stay slightly underweight on duration and move gradually towards neutrality. Inflation protection strategies remain in focus for H2 2023.

The upcoming economic slowdown is not priced by credit markets. We maintain a quality focus, with a preference for Investment Grade credit over High Yield.

The impact of monetary tightening on corporate fundamentals has been limited so far, because of the huge liquidity accumulated during the Covid-19 crisis and low short-term refinancing needs. The transition towards higher funding costs will be more painful and faster for low HY-rated corporates, which have less ability to generate cash flow and higher short- term refinancing needs. Current valuations do not reflect this risk. As such, we favour quality credit, for which fundamentals remain good and valuations fair or even very cheap for European investment grade.

After a challenging first half of the year for EM equity, harmed by negative sentiment towards China, we expect a better environment in H2 2023. EM equity could benefit from: 1) attractive valuations, particularly in LatAm and EMEA; 2) the approach of an end to the Fed tightening cycle (possibly transmitted into EM CB easing); 3) the expected dollar depreciation.

We expect earnings to return to positive YoY growth after two negative quarters — especially in EMEA and EM Asia — as EM economics should prove relatively more resilient in terms of growth trends compared to developed economies. Margins started to recover in Q1 2023. This trend should continue in H2.

While EM bond yields have dropped in H1 2023, the asset class still offers an appealing entry point in terms of spread and carry, supported by a weakening dollar. We maintain an upbeat outlook, particularly for LatAm, where the hiking cycle has ended and should reverse in H2 2023 over decelerating inflation. Hard-currency bonds are expected to yield high-single-digit returns on a six-month horizon and volatility remains limited. We favour HY, which offers more appealing valuations. Conditions in the EM corporate bond space are improving, with corporate net leverage levels well below those in the United States.

As the US economy loses its exceptionalism in economic growth and interest rates, investors should look elsewhere for higher returns, leading to a shift away from the dollar. With the end of the Fed tightening cycle, EM CB should turn towards an easing cycle, thanks to peaking inflation rates which should be on a declining trend in H2 2023. While undervaluation and light positioning on EM currencies could contribute to an asset class recovery, we recommend a selective approach.

Oil demand and prices are cyclical, sensitive to the economy and to consumer reaction to high prices. Yet, oil has disconnected from macro forces several times in the past. This has occurred when supply could be adjusted quickly, when macro deterioration was manageable or in times of an oil supply shock. We foresee oil demand to stay resilient, supported by China’s decoupling and amid a manageable contraction of the global economy. OPEC+ also has the upper hand – without heavy competition from US producers, with declining Western leverage and thanks to DM’s chronic under- investment – allowing the cartel to act on supply more decisively. Following a period of range trading, we see prices gaining traction later in H2 upon evidence of market tightness. We then expect Brent to reach $90/barrel.

In the past, the financial industry tended to downplay the USD’s dominance in global markets. While reality has invalidated this pattern – USD remains involved in 90% of global transactions – the current cycle has strengthened the argument. USD overvaluation is part of the story, but global capital flows may also be involved this time. A gradual repricing of the Fed’s rate path is the cyclical condition that we expect will reconnect the USD to where it should trade, based on the regime shift we experienced last year. The amount of outstanding negative-yielding global debt has plunged, and the interesting asymmetry arising from global portfolio activity – the potential for EUR-based investors to repatriate vast amounts of money into domestic bond markets – suggests a weaker USD profile moving into year-end.

We are at a complex, macro inflection point, shifting from rate hikes to a growth slowdown. Opposite forces will fuel above-par volatility, opening market- timing windows. CB are nearing peak rates, but sticky inflation will keep some unpredictability in bonds, providing relative rather than directional trades for macro managers. Meanwhile, the impact of tightening will deepen the growth slowdown, yet remain orderly thanks to China’s growth acceleration. Alpha should see asset differentiation with reasonable correlations, prices trading closer to fundamentals and country arbitrages.

Listed and private markets have not yet repriced for a worsening outlook. Looking ahead, while some areas could be affected by these weaker dynamics, we expected private markets to remain resilient with some differentiation among assets. We particularly favour infrastructure thanks to its cash-flow features, stable pricing and strong growth outlook, which is being boosted by the energy transition. Along with public funding, private capital is required to build renewable energy plants as well as enhance the digitalisation of networks.