SUMMARY
We continue to look for a stall or recession for the world economy in 2023 as the usual lags between tighter monetary policy and economic weakening unfold. Our latest issue of The Quadrant draws attention to current downside risks and addresses investors' concerns.
Our asset allocation remains unchanged with global equities 2% underweight and fixed income 1% overweight (gold and cash are the balance). Beneath these global aggregates, our asset allocation remains tilted toward defensive, higher quality income generation with an overweight to US dollar assets.
While the Fed continues to tighten rapidly, future restraints on growth continue to accumulate. We believe investors should be patient to see this impact unfold before discounting either a swift economic recovery or a long-lasting (and debilitating) rise in inflation.
Economic decline ahead
Severe declines in US home sales and surging goods inventories in recent months point to declines in production, trade and related employment in 2023. Virtually none of this economic decline has already unfolded in corporate profit measures or labor income.
As usual, markets in 2022 are leading economic developments. While we would expect corporate profits to grow and post a record high in 2022, we expect profits to decline about 10% in 2023. Looking ahead, we would expect financial markets to bottom sometime in 2023, well before economic growth and profits show improvement.
Despite forward-looking markets, we still believe the June/August equity rally was premature. An inverted US Treasury yield curve has signaled recession ahead with a variable lag averaging 10 months since 1960.
Average US equity returns have been positive from the time the yield curve inverts and before recession ensues. The S&P 500 has rallied as much as 23% before losses are typically suffered during half of a pending recession period. This observation seems important now as a strong bearish consensus emerges, expressed through historically high levels of equity and bond short positions. These can drive strong counter-trend rallies that aren’t indicative of a new economic cycle.
Peak energy costs to be expected
Among the strongest consensus trades, the US dollar has had a one-sided rally in 2022 to date. The Fed has led other developed-market central banks in tightening more abruptly in the year so far. Energy importers among developed market economies in Europe and Japan have also suffered a severe terms of trade shock as Russian gas imports have been cut off. Most emerging markets have been comparatively insulated with early rate hikes and strong commodity trade balances.
Europe’s energy supply crisis may lead to a long-lasting drop in competitiveness. At the same time, natural gas prices tend to overshoot, with winter demand being highly unpredictable. While too soon to tell, it is possible that peak energy costs will be reached in the 2022/2023 winter with potentially excessive declines in European assets (which we currently underweight). If this results in a strong overshoot for the US dollar, conditions may be ripe for a reversal in 2023. This could impact our US-dollar centric tactical asset allocation in the coming year.
In short, we believe wide, volatile ranges should be expected in the months to come given the scope of macroeconomic shocks and central bank policy tightening steps. Even after substantial global equity declines, we believe investors should tactically focus on the most reliable sources of return: sustainable dividend payouts and bond coupon income from the strongest investment grade issuers and governments. Evolving economic conditions and macro policies will alter this risk calculus in time.
