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lifespan
South Eastern Wealth

At Lifespan, we anticipate an uncertain and volatile year ahead in investment markets. This article should provide you with some context regarding the drivers of the complexities that we face in financial markets.

Reflecting on 2022

At a time of record government and consumer debt levels, 2022 saw the return of persistent inflation for the first time in 40 years, with central banks pushing up rates to levels that deliberately damaged economic activity, at a time of record government and consumer debt levels. This was exacerbated by geopolitical factors that significantly disrupted supply chains and sent energy prices soaring. The UK debt crisis also showed that investors are concerned about the management of the massive levels of global debt. 

The result was the biggest market storm in decades. Global stocks finished the year down 18% in US dollar terms (down 12.5% in AUD terms) and making things worse, for the first time in decades, bonds also fell as they were unable to offer either income or diversification benefits, with global bonds (hedged) ending the year down 12%. 

We enter 2023 with global growth and money supply falling rapidly in developed markets and key leading indicators of economic growth in recessionary territory.

GDP

Source: RBA Chart pack December 2022

 

Outlook for 2023

While the equity markets have had a good start to the year, Lifespan’s base case is for a global recession in 2023. We believe the chances of the recession to be a deep one, such as in 2008 which saw GDP at negative 4%; the S&P 500 decline by 53%, and corporate earnings decline by 36%, as being low to moderate. That recession lasted for 16 months. Rather, our base case envisages an average recession in the US where GDP growth is negative 1-2%; earnings fall by another 5-15% from these levels and the S&P500 falls by 15% – 25% from these levels. Further, we expect most economies to follow the US into recessions with varying degrees of severity and timings.

On a positive note, we do not expect this to be a very long recession, with the recovery in the markets likely to at least have started in the second half of 2023 which may result in the markets producing a moderately positive or negative return for the calendar year.  

Our recession view is based on a belief that while core inflation is declining central banks will not cut rates as quickly as consensus forecasts due to fear of inflation rising once again from cutting rates too soon. Further such a recession and the likely sharp fall in corporate earnings are not fully reflected in current stock prices and valuations in our view. 

The difficulty in making a prediction for 2023 is that even the optimistic market consensus of 3.5% for core US inflation is significantly higher than the Fed’s stated target of 2%. The market is betting that the Fed will pivot, and ease rates much more quickly than the Fed has stated in its intentions. The actions of the Fed in a recession will determine how quickly any recovery occurs. In Australia, unlike in the US, inflation continues to rise meaning that interest rates here are likely to rise and be held at high levels even if the US Fed pivots in 2023. The recovery in the Chinese economy, largely due to the ending of China’s zero COVID policy, is a positive for the global economy, especially for commodity producers like Australia.  A further complicating factor is that we are entering a point in the cycle where earnings are declining, but declining bond yields provide valuation support to equities.

Overall, with fixed income being quite attractive we have a cautious view on risk assets in our core portfolios and an overweight position to longer term bonds and anticipate being so until at least mid-2023 when we expect conditions will become clearer. However, we monitor the market environment and are ready to change our positioning as needed to suit the prevailing conditions.

High probability of US recession

The market is factoring a 65% and higher probability of a US recession. 

recession

Source: GSAM

Inflation moderating and inflation expectations falling.

US inflation continues to decline with CPI inflation declining to 6.5% and Core CPI down to 5.7% to the end of December 2022. Consensus inflation forecasts which are driving the current rally in markets may be overly optimistic given the upward pressure on wages and services and are above the Fed’s target level of 2%.

inflation

  Source: St Louis Fed

 

Despite inflation declining, market sentiment is poor.

The charts show that business and investor confidence in the US and consumer confidence in Australia are at low levels and declining. 

fred

Source: St Louis Fed

consumer sentiment index

Source: Westpac

Fund manager return expectations for 2023 vary significantly. 

According to Wall Street’s finest, 2023 could be a pretty good year for markets despite the high probability of a US recession. Only 3 of 23 forecasters see the market going backwards with the median forecaster seeing a price return of around +7%. 

 The range is wide though with the highest forecast seeing a +24% return and the lowest -11%.

                  

fund manager
 Source: Ophir Asset Management


Fund manager return expectations for 2023 vary significantly. 

The range is wide though with the highest forecast seeing a +24% return and the lowest -11%.

The bulls are betting on the soft landing scenario. They do not believe the Fed’s forecast to hike rates to over 5% leaving Fed funds unchanged in 2023 with limited easing in 2024. They are pricing more aggressive easing as they don’t believe the Fed will hold firm and keep rates high in a recession. They are also betting that inflation will fall rapidly as supply chains are restored and demand declines due to a recession. Further, some think that PEs will expand even while earnings are declining. 

Not everyone is optimistic however, Vanguard’s base case for 2023 is a 90% likelihood of a recession in the US, UK, and Euro area and BlackRock see a difficult year ahead.

Vanguard places the odds of a recession in Australia at 40% because wage and inflation pressures are more muted in Australia, meaning interest rates will not need to rise as much. Australia also stands to benefit from a cyclical rebound in China (currently in recession), and as a net exporter of commodities given elevated commodity prices.


We think a “soft landing” is not likely.

Despite being a popular forecast by some fund managers, Lifespan believes that a soft landing is not likely, and to believe that there will be one in 2023 is overly optimistic and ignores both Jerome Powell’s statements in the last two FOMC meetings including “the Board expects to increase rates further in the period ahead”, and the lessons of history. The risks of adopting a soft landing strategy as a base case are many:

  • inflation remains elevated in Australia and the US partly due to record labour shortages, especially in the US;
  • although goods costs are falling, services inflation remains elevated;
  • the Fed is unlikely to cut rates until at least late 2023 and then risk inflation rising again in 2024 as they have told the market they won’t cut rates till 2024;
  • liquidity is at low levels at present which does not support financial assets in the near term
  • investor and consumer confidence are at near record lows;
  • we believe a recession is not fully reflected in current stock prices and valuations, particularly an average or deep one. 

While we agree with Vanguard in terms of the relatively better outlook for Australia, we do not expect the ASX to outperform significantly (as it did in 2022) because value stocks that dominate the index, especially materials and banks do not traditionally perform well in global recessions and while the Fed may be reducing rates, the RBA is holding rates at a relatively high level making conditions difficult for home owners and borrowers. However as mentioned, the recovery in China is a tailwind for Australia.

 

Stock prices and valuations – what has been priced in and the downside potential

Accepting the consensus view that there will likely be a US recession, the key issue is what has already been priced into markets and how much further fall is likely, given in our base case – average recession. 

The fall of roughly 20% for the S&P 500 in 2022 does not reflect both the significant increase and speed of increase of interest rates. History shows that falls in the S&P 500 in previous tightening regimes were in the order of 45%, suggesting a possible further fall of up to 25% in 2023.

 

Stock prices – market recovery and upside potential

Analysis shows that since 1950, recessions are not very long, averaging 10 months. Importantly, while stock markets typically lead the economy into downturns, history shows that they rebound about 6 months before the economy recovers. This may occur in mid-late 2023.

This is well shown in the following chart from Capital Group:

economy

How we seek to respond to the market and focus on potential opportunities.

Asset Allocation

Flexibility is paramount (not set and forget). Until last year, portfolio construction could be largely set and forget as both equities and bonds outperformed due to fiscal stimulus and interest rate falls. Lifespan believes that going forward, returns will be lower and more volatile in growth asset classes and that correlations will normalise creating opportunities in defensive asset classes that have not been available in recent years. The following chart illustrates this point, bonds are better value on a risk adjusted basis than equities and the declines in excess liquidity and economic conditions do not support equities.

stocks vs bonds

In addition, the construction of portfolios in each asset class needs to be flexible. As this cycle plays out, opportunities will emerge and disappear relatively quickly. In the current year, your adviser may see opportunities in areas such as dividend stocks, value investing (stocks selected based on valuation metrics), small caps (stocks with market cap less than the top 50 stocks), quality and defensive stocks, selective emerging market equities, and the fixed income sector which may provide both income and diversification benefits (they are likely to hold up when stocks fall). Finally, while we are cautious about listed property trusts, we are positive about listed global infrastructure.

In this environment, we recommend active management as it has typically outperformed passive management during market corrections as the fund managers can avoid stocks that are vulnerable to downturns and have the opportunity to capture more upside as the market recovers.

 

Conclusion

The economic conditions ahead over the next few years and the implications for investment markets will be challenging. Greater market volatility means that Lifespan will be working hard to assess market conditions, make appropriate portfolio changes, and seek to capture opportunities. The role of your professional financial adviser is to continue to educate and inform you about market conditions and ensure that your portfolio continues to meet your investment needs, objectives, and circumstances. Quality financial advice will provide you with the confidence that your investments are well looked after, despite a potentially bumpy road ahead. We encourage you to reach out to your adviser to discuss how your investment portfolio is ready to respond to these predicted volatile market conditions.

Speak to us today!

 

The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decision in respect to a financial product, you should seek advice from an appropriately qualified professional. 
We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser. 

Mark Butters ( ASIC No 423985) is an Authorised Representative / South Eastern Wealth Group Pty Ltd (ASIC No 1298725) is a Corporate Authorised Representative of Lifespan Financial Planning AFSL No. 229892