2023 Outlook & Themes: From Bitter to Sweet

A moderate recession in developed economies

The Eurozone and UK may already be in recession. We see a 65% chance of US entering recession in 2Q 2023. Japan is also likely to be in recession in 2H 2023. On the contrary, we forecast a rebound in China GDP growth to 4.5% amid post-Covid re-opening.

Majority of the rate hikes are behind us

We expect inflation in the US and Eurozone to decline gradually to around 3-4% by end-2023. The Fed will likely raise rate by 50bp in December 2022 and another 50bp in February 2023 with terminal Fed funds rate at 5% by end-1Q 2023. For the ECB, we expect rate hike by 50bp in December 2022, and altogether 75bp in 1Q 2023 with terminal deposit rate at 2.75% and refi rate at 3.25% by end-1Q 2023. We expect both central banks to pause for the rest of 2023 and start to cut rate in 2024.

Lock in attractive yields

We have turned more positive on bonds after  significant re-repricing of rates this year with a lot of quality and defensive assets now paying attractive yields. Yields from US Treasuries and investment grade bonds are now higher than US equity dividend yields in general, the first time since 2004.

We upgraded US Treasuries and Investment Grade bonds from neutral to positive in October, which coincided with the recent peak in yields post better-than-expected US CPI numbers.

With policy rates probably peaking in 1Q 2023, investors could look to extend duration and lock in the attractive yields.

Peaking dollar favours non-US equities

With the Fed’s peak hawkishness probably already behind us, this would possibly imply that the peak dollar may also be seen. Historically, peaking dollar tends to coincide with outperformance in World ex-US equity markets.

European equities: We upgrade Europe equity market from neutral to positive. Sharp decline in oil and gas prices recently helps ease inflationary pressure in Europe, a market which is under-owned by investors due to the concerns of Ukraine/Russia war. European economies are likely already be in recession now and a lot of negatives on geopolitical tensions and stagflation are priced in amid significant outflows from the region’s equity markets this year.

China’s pivot in Covid policy: We turn more positive on the broad China markets. Beijing has been relaxing a lot of Covid restrictions recently despite rising number of Covid cases, a game changer for the domestic economy. We expect to see a cyclical rebound in economic data and corporate earnings next year, thanks to the pent-up domestic demand. Hence, investors should consider to buy on dips.

Read Investment Navigator October 2022: Is the US Economy Heading into a Recession?

Cautious on US large caps: Despite significant sell-off in US equity markets YTD, we remain cautious, especially on large caps, due to the following reasons:

1)Earnings risk: Earnings estimates still look too optimistic in the context of recession with 2023 consensus EPS growth at +6.5% for S&P 500 and +11.3% for Nasdaq. Further downward revisions in earnings are headwinds to equity performance.

2)Credit risk: Credit spreads have widened this year, but are not close to levels usually consistent with a recession. Growing concerns on credit default or credit event would trigger further widening of credit spreads especially in high yield bonds if economic fundamentals continue to deteriorate.

3)Liquidity risk: Despite majority of rate hikes probably behind us, the Fed’s quantitative tightening is on-going which would continue to tighten financial conditions. Furthermore, in spite of the bearish sentiment on US equities this year, US ETFs still registered significant inflows. Hence, US large caps are vulnerable if investors unwind their years of inflows amid worsening economic prospect in the US.

From bitter to sweet

Risk assets in general could remain volatile in 1H 2023 given the uncertainty of US recession. A deeper-than-expected recession should see more downside, while a soft-landing would be a positive surprise. Hence, we recommend investors starting the year with a diversified portfolio including alternatives (private assets, hedge funds, etc.) and focus on quality and income.

We may be able to see a better 2H for risk assets when the recession is realized/priced in and market starting to look for rate cuts from major central banks. Hence, any significant market weaknesses are opportunities to gradually increase equity exposure, especially to non-US equities, throughout the year.

2023 Investment Themes

We have altogether 5 investment themes for 2023. Theme 1 “Looking through the inflation and rates peak” is a macro theme that focuses on exposure to quality credit and non-US assets to play the peak yield and dollar narrative.

As we expect the market to remain volatile in coming months, Theme 2 “Seizing new income opportunities: from TINA (there is no alternatives) to TARA (there are reasonable alternatives)” and Theme 3 “Embracing market volatility” focus on lower portfolio volatility through investment grade bonds, hedge funds and other income-focused equities, structured products and private assets.

Theme 4 “Investing in a new era” and Theme 5 “Accelerating energy efficiency” are longer-term structural themes that focus on energy, food and tech security in the new era, and carbon reduction theme. Investors can consider to get exposure through structure solutions that limit the downside while capturing the upside.

CIO Asset Allocation