Spring is nearly here, for the northern hemisphere at least. Light and warmth can often bring a natural optimism, particularly after a difficult winter. Economic and investment terminology can itself support this seasonal optimism: talking of the “green shoots of recovery”, for example.
Nevertheless, as recent events have made clear, this remains a very difficult investment environment that needs to be navigated with great care. Inflation, the central banks’ response to it and the economic and corporate implications of this remain key. Even after recent declines, current market valuations still implicitly assume that an economic “hard landing” can be avoided – in other words, that the Fed and other central banks can maintain an appropriate monetary policy approach, tight enough to cool economies without tipping them into recession or prompting major sectoral setbacks.
Despite their knowledge and skills, central banks could still struggle to get this policy “flight path” right. Sticky inflation in major economies in early 2023 and the recent deterioration in financial conditions now makes their task even more difficult. These factors compound the three pre-existing questions over monetary policy. First, what will the size of the impact from policy tightening be? Second, how quickly will this impact materialise? Third, can existing policy structures manage this process?
Many factors still argue for central banks keeping policy tight in order to lower stubbornly high core inflation. It is now widely accepted that a given amount of monetary policy tightening now has less of an impact than in previous financial cycles: still strong labour markets may also delay its impact, as could lingering effects from pandemic fiscal stimulus. Technical questions also remain about the future changes to policy approaches and structures, as may first be attempted by the Bank of Japan.
Ultimately, nonetheless, central banks will prevail: our forecast is for inflation to fall back over the next year, although it will stay above target levels. Our central scenario remains for Fed and ECB policy rates to reach “terminal” (peak) levels quite soon. But recent market expectations of Fed rate cuts in the second half of 2023, as a result of regional banking distress in the U.S. and associated concerns about market liquidity, seem overdone. We see no systemic risk given that the decisive response of the Fed so far and the robust measures already implemented in the Eurozone following past financial crises.
Financial markets may stay wary, however. Even under the assumption that the rate cycle can be managed, the potential for higher yields will keep riskier corporate bond assets under the spotlight, although we do not expect major spread widening. Equities’ gains seem likely to be modest over the next 12 months, held down both by higher interest rates and the likelihood that corporate earnings expectations have further to fall. As investors will be aware, there are now plenty of alternatives to equities as an asset class.
Policy risks are, of course, not the whole story. Geopolitical risks are clearly still major. Downbeat recent corporate earnings results also suggest that many firms are reaching the limit of their abilities to boost revenues and profits as falling real wages moderate volumes and pricing power: as always, the consumer is ultimately king.
We also need to be careful not to let a focus on immediate market trends distract attention
from larger-scale structural change. Recent history should remind us that long-term issues (e.g. demographics) can start to be relevant much sooner than you think – note China, for example. One red thread running through structural market and economic change is ESG investment. This will continue to have an impact on immediate and future investment practice and risks, and cannot safely be ignored, whatever one’s individual priorities. Tech is another issue of major continuing relevance, irrespective of the ebbs and flows of sectoral stock prices. These two issues of ESG and tech are now increasingly intertwined. It is notable that our long-term investment themes, summarised later in this publication, fall naturally into three groups: resource transition, population support and next-phase technology.
In summary, we stick to the overall view presented in our 2023 outlook. Spring may be here, but sticky inflation and shifting monetary policy expectations – prompted for example by earlier-than- expected rate cuts – could continue to trigger short-term volatility in bond and equities markets. This will be a case of recovery constrained. Structural economic and market changes add further to the need for portfolios to be managed with great care and attention: we aim to help you to do this.
Christian Nolting
Global CIO
