After a tough year, financial markets have staged a revival in the final quarter. Stubborn inflation, rapid central bank policy tightening and concerns about a potential global recession saw a culmination of bearish sentiment in October 2022.
A tentative lift from these October lows gathered pace in November with the release of a better-than-expected inflation print in the US. This has been followed by a second lower-than-expected US consumer price index (CPI) reading last week. As a result, the key macro force weighing on markets in 2022 is now receding as a risk in our view.
Central to our base case view is that we see a continued downtrend in US inflation, supporting a more positive trend for both equities and bonds in 2023.
Mixed Signals from the Fed this Quarter
Alongside an improving inflation trend, recent comments from the US Federal Reserve, suggesting the potential for a slower pace of rate hikes, were also positively received by the market, despite the Fed’s accompanying comment that their job was not finished. Last week the Fed raised the official policy rate by a “slower” 50 basis points (bps). The cash rate target now sits at 4.25 - 4.5%. This compares to the 0% - 0.25% starting point for 2022.
While this move was widely expected, the Fed did twist the story yet again by delivering a somewhat more hawkish message in terms of the interest rate outlook for 2023. The Fed raised their guidance for the peak (terminal) cash rate to 5 - 5.25% next year. This represents an increase of 50 bps from their guidance 3 months ago. It is also moderately above the current futures market projection, which has US cash rates peaking just below 5%, or 25 bps below the Fed’s new guidance. Perhaps more importantly, there appears to be a clear gap between the Fed’s updated guidance, which implies rates will stay on hold until the end of 2023, and the futures market pricing for 2 rate cuts towards the end of the year.
Fed Likely to Pivot in 2023 Despite Last Week’s Hawkish Guidance
We tend to side with the view of the futures market, based on our expectation of easing inflation and a further slowing in economic growth. We would not put a huge weight on the Fed’s forward guidance, particularly when we remember that 12 months ago the Fed was guiding to only 100 basis points of tightening in 2022 (we got almost 450 basis points). Ultimately, we expect the Fed to pivot next year, which should be positive for equities, all other things being equal. However, the risk that the Fed keeps policy too tight for too long does pose a risk to our “no US recession” outlook.
China Growth to Buck the Global Trend in 2023
Beyond the market’s intense focus on the US inflation and interest rate outlook, China’s faster-than-anticipated pivot to an exit plan from its zero Covid policy has also buoyed global markets of late, particularly emerging markets, the AU$ and China-related commodities (e.g., copper and iron ore). Despite what is likely to be a bumpy process, the prospect that China’s reopening drives a significant acceleration in the country’s economic growth rate next year should support renewed interest in the Chinese equity market, providing a cushion for what is likely to be significantly slower growth in the developed world.
European Recession Looks Likely but US and Australia Should Avoid Recession
Europe will be the clear weak spot in 2023, with a growth recession looking inevitable, although easing gas prices in recent months are likely to reduce the severity of the slowdown, assuming they are maintained. While the European outlook appears rather somber, economic growth will slow but we should avoid recession in the US and Australia.
Sluggish Year for Corporate Earnings but Policy Shift to Buoy Stocks
We believe the earnings downgrade cycle that has been playing out in the US has further to go, although it should not be overly severe. Australia is also likely to slip into a moderate earnings downgrade cycle. History has shown that stocks can rise into moderate downgrade cycles, particularly if interest rate conditions become more supportive, as we expect. We see potential for economic and earnings growth to pick up again in 2024 as interest rates ease. This growth pick up should become an increasing focus for the market as we move through 2023.
Shifting Drivers Laying the Foundations for a Better Year
In summary, while there are still a number of risks to the outlook, we see the three key shifts that have developed in the last couple of months – namely, lower inflation, easing US rates and an improved China growth outlook – as durable themes to take into 2023.
We edge our global equity weighting up from a slight underweight to neutral due to these encouraging albeit tentative shifts in the macro landscape. A still hawkish Fed and the slowdown in global growth that is unfolding poses risks, but our base case is a relatively soft landing from an economic growth and earnings perspective.
We retain a neutral call on fixed interest, with US and Australian bond yields looking fair to slightly cheap. Our base case is for yields to drift lower over the next 6 to 12 months, as inflation eases, growth slows and focus turns to the prospect of central banks beginning to lower policy rates. A hard landing is the key risk for credit markets; however, our base case scenario of a soft landing should be supportive of current credit spreads. We note the implied default rate in the global high yield market is below recessionary levels but still implies a default rate way above the current very low rate.
While we stay diversified across equity investment styles, our batting order for 2023 is: quality marginally ahead of growth (this year’s big loser), which we place marginally ahead of value (more cyclical). We do not think investors should obsess about aggressively backing one particular style over another. We doubt one style will dominate to the extent that growth has dominated over the past 5 to 10 years.
Emerging markets should do significantly better in 2023 as China picks up and the US$ declines. We see emerging markets (EM) as having potential to surprise a seemingly bearish consensus to the upside in 2023. As such, EM is
our preferred candidate for adding some global exposure followed by the US market.
Small caps will have to negotiate a slowing growth backdrop, though given the very large valuation gaps that have opened up in 2022 (and our no recession call), we would have a moderate overweight exposure.
We edge down our Alternatives (Alts) weighting to fund our addition to global equities. Alts are still a key part of our strategic asset allocation but we continue to edge our tactical allocation lower as the outlook for both bonds and equities improves. Gold (AU$ hedged) and infrastructure are our favoured Alts allocations for 2023 (as rates decline), though we continue to have a broad allocation across private equity, private debt and market neutral hedge funds, alongside infrastructure and gold.
| Asset Class | Tactical Tilt | Movement | Wilsons View |
| Cash | Underweight -2% | no change | Underweight as fixed interest and Alts look likely to produce better 12-month returns. |
| Fixed income (Domestic & Global) |
Neutral | no change | Australian bond yields are looking fair value after the big rise in yields in 2022. |
| Equities - Domestic | Overweight +1% | no change | Australia has lower recession risk and AU$ has upside potential, however, sector mix (mining , banks) may not be as favourable in 2023 relative to global equities. |
| Equities - International | Neutral | 1% | We have edged our global equity weighting up from a slight underweight to neutral due to an improved inflation outlook and the likelihood of peaking policy rates. A still hawkish Fed and the looming slowdown in global growth poses risks but our base case is a relatively soft landing from an economic growth and earnings perspective. 40% hedge back to the AU$ as we believe the AU$ has upside against the US$ as Fed pivots and risk aversion fades. |
| Alternatives | Overweight +1% | -1% | Trimming expsoure due to improving outlook for global equities. A range of growth and defensive alternative strategies appeal, i.e., infrastructure, long-short equity hedge funds and private credit. Gold (now AU$ hedged) appeals as a portfolio hedge against geopolitcal risk plus a beneficiary of an eventual US$ unwind. |
*Our tactical tilts represent our view over the next 6 to 12 months though active tilts could be held for shorter or longer periods depending on both asset class performance and fundamental developments.
Source: Refinitiv, Wilsons.
Wilsons Investment Strategy Group wish clients and their families a happy holiday season. We will return in late January 2023 to once again share our views on key investment trends and opportunities. Enjoy the break!
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
About Wilsons Advisory: Wilsons Advisory is a financial advisory firm focused on delivering strategic and investment advice for people with ambition – whether they be a private investor, corporate, fund manager or global institution. Its client-first, whole of firm approach allows Wilsons Advisory to partner with clients for the long-term and provide the wide range of financial and advisory services they may require throughout their financial future. Wilsons Advisory is staff-owned and has offices across Australia.
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