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Written by: Kelly Chung | Value Partners Group
2022 was a very volatile year. Geopolitical events and inflation were in focus in developed markets. All asset classes except the US dollar and selected commodity prices have been hit hard in 2022.
The positive correlation among asset classes has been one of the highest in history, and investor positioning has become very extreme. The volatility in currency added to the difficult investment environment. 2023 will continue to be another volatile year.
The US and Europe will be facing higher recession risk. Inflation will remain high and central banks need to continue to tighten. The governments in the US and Europe will find it more difficult to use fiscal policies to support the economies when their monetary policies are still in a tightening mode. Therefore, the US and Europe will likely head into recession, especially Europe, which has a high chance of going into stagflation.
On the other hand, China faces a different economic cycle. After facing some very hard times due to the property sector slump, the long COVID lockdown and fading export growth, China is now about to turn around with a direction towards gradual reopening and growth development.
There will be more supportive policies helping the economy heading into a recovery. Liquidity is ample in China after a significant increase in credit supply this year. When confidence stabilises, we believe consumption growth could lift the economic recovery.
Other emerging markets and South Asia are still in an expansionary stage although the pace of growth will be slowing. They will continue to benefit from the full reopening although the effect will be fading into 2023. Most Southeast Asia countries are having a healthy current account surplus. Their economies will be supported even though the US is still under a rate hike cycle.
In the US, inflation has peaked, and with the higher base going forward, inflation will continue to slow down. However, service inflation, such as rent and wages, are sticky and more difficult to come down significantly although they are trending down. Therefore we believe inflation will remain higher than the Fed’s 2% target in 2023.
Currently, real interest rates in the U.S. remains firmly negative. History told us that in order to slow demand and lower the pressure of service inflation, a positive 1-2% real interest rate is needed. Therefore, we believe the Fed will continue to hike rate at a slower pace but for longer. With the accumulating effect of rate hike, the U.S. economy is difficult to avoid a recession. It is also indicated by the inverted yield curve. Historically, every time when the yield curve was inverted, the U.S. economy was followed by a recession. On the other hand, as I mentioned before, Asia, particularly China will fare better under this difficult global environment as the countries have more tools to support the economies.
Regarding valuations, valuation in Asia, particularly China is more attractive. In the U.S. current consensus on earnings growth for next year is still positive 5%. With the current expectation, S&P 500 is still trading at 17x. Some sectors, such as technology and consumption, have already lowered their earnings guidance and performed cost cutting aggressively as demand slows. Therefore, we believe that under a deteriorating economic environment with tighter liquidity, negative earnings growth is possible for next year. As such, both earnings expectation and valuation multiples have to come down. Therefore, there will be more downside in U.S equities. On the other hand, valuation and earnings growth are more reasonable in Asia. Valuation in China is at historical low range. Company earnings have bottomed and we still see upside to the current earnings expectation.
With the gradual fine tuning on the COVID policy towards reopening, Chinese equities will be gradually recovering from their bottom and re-rating should be warranted when sentiment improves. In conclusion, 2023 will continue to be a volatile year. We prefer equities over fixed income overall. Fixed income will perform better than this year as a large part of the rate hike expectation has been priced in, however, upside is also limited. The inverted yield curve made the term structure unattractive. Credit spreads in both investment grade and high yield bonds in developed markets have not widened much and the risk of further widening remains as more earnings downgrade will be coming and with the potential of economic deterioration and earnings recession.
On the other hand, after a distressing year in Asian credits, with fears spreading from the Chinese property sector to the whole asset class in 2022, there is good investment opportunity in healthy companies with strong balance sheets. Credit spreads have started to stabilise, and valuations are now attractive.
However, focusing on the higher quality spectrum and credit selection remain crucial while maintaining a lower duration stance. On the equity side, we prefer Asia, particularly North Asia, as China will lead the recovery and re-rating of the stocks. On the alternatives side, we believe energy will remain supported while gold is a good hedge against any escalation of geopolitical risks. Overall, an active allocation is needed to manage risk carefully under such a difficult market environment.
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