Stock Market and Economic Commentary January 2023

“Prediction is very difficult, especially if it’s about the future!”

Niels Bohr,1885-1962, Danish physicist, Nobel Laureate in Physics and Father of the atomic model and quantum theory.

Forecasts, predictions and crystal balls

January is often a month of dismal days and long dark nights, but it can also be the time for new beginnings, new opportunities and fresh ideas, quiet optimism and determination, a time to work harder and think more deeply. A time to review financial plans and investment strategy.

For myself, it is also a time for trying to make sense of the many economic and financial forecasts. A multitude of predictions for the performance of everything you could possibly imagine in the coming 12 months. Macro or micro, recession or recovery, bonds or equities, value or growth, Sterling or the Dollar, Wall Street or the City of London, the Nasdaq or Emerging Markets, Putin or Biden, war or peace, tears of rage or tears of joy.

Yes, it is that time of year again and forecasts are upon us. They crowd the inbox of the average financial planner and wealth manager much like heavy-laden shoppers once crowded Oxford Street in early January. What they offer has something in common with a lot of the stuff that is bought in the winter sales – not much use at all. But some forecasts ring true, and I admit that I have my favourites and the optimist in me tends to favour the more upbeat ones. Throughout the ages, optimism trumps pessimism hands down but I try to take a balanced view of the world and where we are heading.

Forecasting the next 12 months is fraught with difficulty as arguably the global economic outlook is more uncertain today than at any time in the past 50 years. However, one thing that is certain in an uncertain world is that inflation is back in a serious way for the first time in decades, forcing central banks to raise interest rates at the fastest pace since the early 1980s. This sudden change in the price of money is the most important driver of economic and financial behaviour and marks a fundamental break with the recent past.

Unfortunately, on the assumption that central banks will once again come to the rescue, some investors are still pouring money into ideas that worked in the last decade such as cryptocurrencies and high-risk tech companies with zero profits. Governments are still borrowing to spend, and highly geared businesses are unwilling or unable to adapt, as if easy money is bound to return soon.

But tight money is not a temporary shock. The new standard for inflation is closer to 4 per cent than 2 per cent. Interest rates will fall back as inflation falls from the dizzy heights of last year but are unlikely ever to fall back to zero, or even close to zero. As this phase wears on, tycoons, companies, currencies, and countries that thrived on easy money will stumble, making way for new winners. The time of lavishly ridiculous digital coins, video games and TV shows will pass but some things will improve. An age of more discriminating judgement will shape the trends for 2023 and beyond.

The USA

The US is one country that has thrived on cheap money. The dollar has been the world’s dominant currency for more than a century, eight years longer than the average for its five predecessors going back to the 15^th century. But the dollar’s long rule has been far from a steady climb, instead rising and falling in long cycles. Its two major upward swings — one started in the late ‘70s, and another in the mid ‘90s — lasted about seven years, yet by last October its latest upswing was 11 years old. On most metrics, the dollar is now more expensive than it has ever been making New York the world’s most expensive city for the first time in history.

Decline is overdue. This year the US economy is expected to grow more slowly, and interest rates are set to rise less in the US than in other major nations. These signals point to a further fall for the dollar and less global purchasing power for the Americans, but more for everyone else.

The US has been the best-performing financial market in the world during the past century and so many argue why bother investing elsewhere but consider a more practical timescale. Since the Second World War, the US stock market has tended to outperform the rest of the world one decade then trail behind the next. The 1950s, 1970s and 2000s were great decades for investing outside the US.

In the boom of the 2010s, the value of the US stock market expanded to 60% of the global total, a full 15% above its long-term average. In every other way, the global footprint of the US is much smaller. Less than half of corporate earnings, a quarter of economic output, one-fifth of listed companies and less than 5% of the world population.

With US stock valuations still close to record highs compared to the rest of the world, investors with an overweight exposure to American companies are assuming that the US can improve its position, not just hold it. That may not be a safe assumption, particularly now that the era of easy money is over.

A demand shock from China

It has become fashionable to see China as a country in trouble, but it might be wise not to underestimate its impact.

In the wake of the Global Financial Crisis, it was the extensive stimulus (mainly fiscal) from the Chinese government that pulled the whole global economy out of recession.

The Chinese economy is much bigger today – it has trebled in size since 2008. The strict zero-tolerance Covid regime has had a huge impact and suppressed the demand side of the equation globally. China need not bounce back very strongly for the world to feel a positive impact.

That said, we must assume the Chinese have pent-up demand, as we did in the UK. So, a bounce back may be stronger than we imagine. This should be positive for the global economy and especially positive for Asia – but not so good for inflation. Economics is never simple!

A positive year for Japan?

For years, commentators trying to spot rays of light amid the economic gloom have questioned why Japan is known as the Land of the Rising Sun. Stagflation, a shrinking population and outdated corporate practices have meant Japan has been a perennial disappointment.

But it is perfectly possible to envisage the story changing in 2023. This is the world’s third-largest economy. The weakness of the yen is good for manufacturing. Japan could be a massive beneficiary of a more prosperous Asian economy. It has experienced a lot of corporate reform that should make it better placed to succeed.

And this is one country in the world which would embrace a bit of inflation.

Monetary policy begins to bite

Monetary policy famously operates with “long and variable lags”, but after nearly a year of rising interest rates, it is having an effect. With real incomes falling consumers have switched from the discretionary goods purchases they splurged on in the pandemic and where inflation has been high, towards essentials. This shift is seen in worldwide sales of PCs, which fell by 20% in the year to Q3 2022 or in the prices of second-hand cars that surged in the pandemic and are now falling.

Weaker global demand has led to big declines in commodity prices. Mild weather has helped, with European gas prices halving in December and running 30% lower than a year earlier. Supply chain problems have eased significantly since last summer. Companies in the US and Europe struggled with stock shortages for much of the last 18 months but are now reporting much higher levels of stocks. The cost of shipping freight, which exploded in 2021, is now roughly one-tenth of the levels reached in August last year.

These factors are feeding through the system, with US inflation dropping from 9.1% in June to 6.5% in December. Euro area and UK inflation rates also seem to have peaked, though are still running at higher levels than in the US.

And globally

There is a chance that the global economy proves more resilient than everyone expects. The most under-priced risk is the possibility of a surprise to the upside this year. The return of a more stable environment could buy some time for policymakers and provide respite for economies and stock markets, which have had the most difficult year in more than a century. 2023 certainly won’t be a fairy tale for economies or markets but there is a possibility that it will be a lot less scary than last year.

The macro picture is not quite as bleak as it may sound. Inflation has probably already peaked and helped by lower gas prices, should fall sharply this summer, paving the way for recovery before the end of this year. Recession risks are greatest in Europe, rather lower in the US and lower still in much of the rest of the world. The world’s second and third largest economies, China and Japan, are expected to post strong growth this year, as is India, the world’s most populous economy. The IMF’s widely reported forecast that one-third of the world economy will fall into recession in 2023 could more optimistically be expressed as meaning that two-thirds of the world economy will avoid recession. The reality is that the global economy will continue to grow this year, albeit at a slower pace than in 2022.

Stock markets

2022 was a year that brought shocks to many systems. Few can ignore the fact that inflation is back, and the era of low interest rates has come to an end.

Pivot points like this send tremors through financial markets. Bond markets experienced their worst year in history. The rocketing growth stocks that had driven equity market returns since 2008/9 suddenly ran out of fuel – low-cost capital – and came tumbling back to earth or to a much lower orbit.

Many investors are settling in for a new world order. But we must be careful not to put on the blinkers too quickly. If the past couple of years has taught us anything, it is that surprises come from unexpected places at unexpected times.

Predicting the unexpected is not, therefore, the exercise in futility it may seem. It can pay to remain alert to the possibility of surprises and to challenge widely held assumptions.

One of the most elemental questions of fund management is whether to change or to stand still. In the middle of long-term trends, such as the one towards growth and innovation in the 2010s, the skill in fund management was to do very little, hence the growth in index trackers. Many people will come and present arguments that the world has changed but it rarely has and activity in these periods is usually counterproductive.

Then, one year in ten (on average) the world really does change, and inactivity is the counterproductive choice. Indeed, not changing can undo the good work of the previous nine years. Although it is far from certain, there is a chance that 2022 was that one year in ten.

Change is hard. We all have a bias towards the status quo, and failing while being consistent with previous choices is, wrongly, seen as more acceptable than failing through making new choices. This creates an inherent bias against trying new things, even in the face of strong evidence.

The evidence which built up gradually in 2022 is that the investment environment is evolving into something which could be quite different from the one of recent times. Not to the extent that everything which worked well in the 2010s must be left behind. Innovation, for example, remains the purest driver of investment returns and societal improvement, but evolution is required to capture the best investment opportunities.

The key issue that markets had to work through in 2022 was that inflation results in higher interest rates (as central banks are charged with maintaining inflation at low levels) – and assets are worth less in such an environment. It is far from certain, but there is a credible case to be made that on a multi-year horizon, inflation and therefore interest rates will be structurally higher than over the last ten years. This isn’t really a heroic assumption given how low they have been in recent history. More expensive energy, labour and capital (debt and equity) mixed in with observable de-globalisation will remove many of the disinflationary forces that have been acting on the global economy for so long.

It is possible that we are moving from a time when central banks were an investor’s friend, to one where they are his or her foe. Between 2008 and 2021, each fall in asset prices was met with interest rate reductions and significant amounts of quantitative easing. Last year was the first year when the consequences of this began to feed through to higher inflation – and unsustainable asset prices. It may be that rather than providing a floor to asset prices in the coming years, central banks will try to engineer a ceiling, having to tighten policy in the face of higher inflation, rather than loosening it into falling inflation as has been the trend. Navigating this new paradigm will require preparation and patience and active investment management.

The price of certainty

A key thing to differentiate between is a feeling of certainty and actual certainty. The world felt very certain on 10 September 2001, and we all know what tragically happened the next day. In 2007, the US economy and housing market were booming, but within a year the largest financial system in the world came within hours of collapsing. Things also felt reasonably certain on 31 December 2019, yet within three months a global pandemic had shut the world economy down. Feeling certain should not be confused with being certain.

Equally, on 23 March 2020, when equity markets fell to their pandemic-induced lows, the world could not have felt more uncertain, yet in hindsight that was the point when investment markets were incredibly cheap. The same was true on 15 September 2008, when Lehman Brothers, the US investment bank that became the poster child for the financial crisis, went bust. On that day, the S&P 500 fell to 1193. At its recent peak, on 3 Jan 2022, the S&P 500 was 4796.

Overall, that the future feels uncertain is not the point. It is always uncertain, just sometimes we do not know it. Past periods of high uncertainty have provided useful opportunities for investors, and it is unlikely this time will be any different. While this bear market may have further to go to adequately reflect the economic impact of higher interest rates, it should not stop investors from taking advantage of opportunities as and when they emerge.

Black Swans and Blue Birds

In the late 2000s, author Nassim Nicholas Taleb popularised the “Black Swan”. Written as a theory of unexpected events that can bring destruction, with either good or bad effects. For better or worse, the term became synonymous with negative shocks during the global financial crisis of 2008. People have been on the lookout for black swans ever since.

Now the idea is the ‘good’ black swan may come back as the “blue bird”, a rare unforeseeable event that brings joy. Geopolitical shocks and economic gloom have persisted since 2008 and could get worse in the tight money era but amid endless worries, the world may turn its radar toward positive shocks that could bring relief.

The next blue bird event might be a surprise peace agreement in Ukraine which instantly lowers energy and food costs. A thaw in the US-China Cold War which boosts global trade. A new digital technology that revives productivity helping to contain inflation. None of these may seem likely at the moment but then surprise is the essential nature of blue birds.

Inflation has been the major issue of 2022. Central banks are finally getting the upper hand over spiralling price rises, although no one is being blasé about the remainder of this journey. That’s not surprising given how policymakers were caught completely off guard in 2022. As a result, we’ve seen quantitative easing policies roundly dumped and interest rates driven up to the point where an economic hard landing is feared by investors. However, early January brought some relief in the cabin of the US economy as its pilots try to coax it in for a soft landing when two-year treasury yields – a critically important measure and barometer of where the market thinks rates are moving in the short term – fell sharply. A surprise blue bird event.

I realise these would-be surprises are slanted to the positive, and maybe that is the final assumption we should challenge – the widespread belief that 2023 will be bleak. It might well be, but after the surprises of the past couple of years, it would be nice to have some pleasant ones.

We thank you for your continued support and we look forward to updating you regularly throughout 2023. Please get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

January 2023

Creating better lives now and in the future for our clients, their families and those who are important to them.

Risk Warnings

The content of this article does not constitute financial advice and you may wish to seek professional advice based on your individual circumstances before making any financial decisions.

Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy.  The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds.  Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.

Stock Market and Economic Commentary – January 2023