Reasonably, markets appear stuck between hope that central banks have raised rates enough to bring down inflation and fear that their actions will trigger a recession of unknown depth and length.
So how should investors think about what’s to come?
The first point is to accept that markets are likely to continue to be influenced by changes in the macroeconomic environment driven by central banks.
Macquarie strategist Viktor Shvets’ baseline scenario for 2023 is that inflation should fall faster than expected, giving central banks an opportunity to better balance anti-inflation and growth protection and giving the global economy a chance to avoid a recession.
This may turn out to be optimistic; as Bank of America strategist Michael Hartnett points out, when rising interest rates are simply forcing key indicators to return to long-term averages — US unemployment is at 3.7 percent compared to the 6.2 percent average over the past 50 years , while corporate debt defaults Interest rates are at just 1.5 percent, down from an average of 3.8 percent since 2005 – the real economy could be in for a rough ride.
A “trendless” world?
Shvets, too, says investors need to be prepared for a wide range of outcomes, including the possibility that inflation remains sticky and central banks have to induce a deep recession, with China’s post-COVID-19 reopening triggering a new round of inflation. or another round of Black Swan events like we saw in 2022 with Russia’s war on Ukraine.
But while much has changed in 2022, it’s important to remember that the world remains a place where debt is running high in every corner of the economy and markets, and means the financialization of everything that society is more dependent on rising (or at least least stable) asset prices.
As such, he sees a “trendless” world emerging as central banks constantly adjust course to try to keep markets and economies in balance.
“Unlike in the 1990s and 2000s, we argue that investors now live in a world where the pendulum swings between growth and recession, inflation and disinflation, more violently than in the past,” says Shvets.
“This implies that central banks cannot know whether their compass is pointing north or south, requiring them to abandon any pretense of orientation and embrace rapid policy changes. This is also forcing investors to focus on market signals, regardless of investment philosophies, or on building some form of resilient portfolios.”
Of course, this isn’t a comfortable position for investors, especially those with a high-conviction approach that prioritizes one style (like “value” or “growth”) over another. Value may have been in vogue in 2022, but Shvets says the changing tides in 2023 (falling inflation, less restrictive central banks) could prompt a return to growth.
In his view, investors should respond by prioritizing resilience over high-quality, sustainable growth companies (like Microsoft, Nike, Alphabet, Amazon, Sony, Nestle, LVMH, and Australia’s own BHP) and then look for companies that address megatrends, such as: People, alternative energy, technological disruptors, demographics (funeral homes are an example), and defense and security.
The second thing investors need to keep an eye on in 2023 is math.
Rob Almeida, chief strategist at $600 billion Boston-based giant MFS Investment Management, says while the market is obsessed with what central banks do next, investors have missed the profit slump that is coming next year.
“For me, the math is very simple,” he says at Chanticleer in Boston.
Memories of Bear Stars
Revenue will fall as inflation eases and economic growth slows. But at the same time, costs are rising, or at least staying high — the cost of debt has obviously risen, wages are higher, and rebuilding supply chains for a deglobalized world will require investments that companies haven’t seen in decades.
But Almeida, on Wall Street at least, says analysts aren’t pricing this in as consensus earnings estimates are down just 4% to 5%. He points out that this is eerily similar to August 2008; Bear Sterns had sunk, credit spreads had exploded, and CDOs had exploded, yet earnings estimates had only been cut 5 percent.
He doesn’t think earnings will plummet 50 percent like in the GFC, but he does foresee pain that will hit stock prices in ways the market doesn’t anticipate. “The profit bubble hasn’t burst yet.”
We have seen evidence that the market is lagging behind the earnings curve in Australia this week. An earnings downgrade at retailer City Chic Collective sent the stock down 34 percent on Tuesday, while a softer forecast from real estate classifieds group Domain (partly owned by Nine Entertainment, publisher of AFR Weekend) caused a nearly 10 percent decline.
As rate hikes hit the real economy around the world, earnings shocks are likely to continue and valuations will need to be reassessed. The question, according to Almeida, is which companies will prove the most resilient to margin repricing in their industry?
And herein lies the big opportunity for investors in 2023. The outlook may be uncertain and consensus difficult to find, but Almeida cautions that old-fashioned, fundamental stock selection offers a big opportunity.
That means worrying less about the Fed and the RBA and more about which companies can continue to experience higher costs, which companies have the safest supply chains, which companies have the lowest carbon operations — and which companies may fail or lose ground in a world where money is no longer free.
In a world where fewer and fewer market participants think deeply about fundamentals – whether they are passive investors, programmatic investors, momentum traders or retail investors – there will be opportunities to find value.
Just don’t expect it to be easy.
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