It’s been a challenging year. Across major equity and bond markets, total returns have been negative for much of 2022. It is only in the fourth quarter that they have picked up. Even now, many are sceptical of the rally, given that potential bad news is still to come on inflation, interest rates, economic growth and global politics.
Investor confidence is fragile, and the news is not encouraging. So, what should we expect in 2023?
Across listed bond and equity markets, it is difficult to find any index that is up this year. Most have recorded heavy losses. The biggest losses have been in those asset classes most sensitive to changes in interest rates.
These so-called “long-duration” investments include long-dated bonds and those parts of the global equity market that rely on the promise of stable long-term earnings growth. Assets like long-term US Treasuries and the Nasdaq equity index have suffered more than most.
Much of this comes down to a once-in-a-generation adjustment in valuations. At the core is the reversal of long-term interest rates from the extremely low levels that characterised the era of quantitative easing. Remember, not so long ago, long-term German government bonds were trading with a negative yield to maturity. Thirty-year US Treasuries briefly flirted with a record low yield of 1 per cent during the onset of the Covid-19 pandemic.
These low yields set the tone for valuations across financial markets, allowing equity price-to-earnings ratios to rise well above their long-term averages. Investors benefited handsomely. Global stocks, represented by the MSCI World Index, delivered returns of 16.5 per cent in 2020 and 22 per cent in 2021.
Inflation was the trigger for the valuation adjustment. Central banks around the world were surprised by the strength of inflation and had to raise interest rates aggressively. The extraordinarily easy monetary policies that followed the global financial crisis in 2009 were always going to come to an end at some point.
No one expected it to happen that quickly and investors got a shock as bond yields and equity multiples rapidly normalised to levels that more properly reflected fundamentals.
To my mind, that is done now. Bond yields are in line with expected long-term trends in real GDP growth and inflation. Central banks have in mind a target level of interest rates which will be slightly restrictive by recent standards.
The hope is that this will be enough to set inflation on a lower path. Evidence suggests inflation may be peaking with supply chain constraints and global commodity prices no longer contributing to upward pressure on prices.
We are close to that peak in the interest rate cycle. This means a reduced risk of losses for bond investors going forward. Indeed, the outlook for fixed income is encouraging. Yields are higher and investors can now lock in higher yields without having to take the same kind of credit or maturity risk that they needed to in recent years.
We are already seeing more positive investment returns in global credit markets, including in Asia, where returns from US dollar-denominated corporate bonds issued by Asian borrowers have been very strong since the end of October.
The peak in rates and bond yields could provide opportunities for better outcomes in global bond markets, where income returns will be stronger than they have been for years. For the equity market, the peak in rates is good news. Maybe price-to-earnings ratios have bottomed.
The recent decline in global oil prices is also good news for corporate earnings as it takes some pressure off profit margins, especially for industrials and other heavy users of energy. Oil and gas stocks have massively outperformed the rest of the stock market in 2022. A reversal of that in line with lower oil prices should be to the benefit of sectors like consumer discretionary and even technology.
Peak rates and lower oil prices are two bullish factors in the outlook. However, investors need to be prepared for global interest rates to remain high for some time. Core inflation will be slow in getting back to the 2-3 per cent levels desired by major central banks.
Moreover, economic growth is slowing. Recession is expected in the first half of the year in the United States and the euro area while China’s growth outlook continues to be complicated by Covid-19.
A better year is ahead. The caveat to that is to keep expectations in check. Prospects for outsize capital growth returns are not that great. However, there are better opportunities for income-focused investing. A 6 per cent yield on dollar-denominated good-quality corporate bonds in Asia is not uncommon. Good-quality companies that can sustain profitability and pay dividends will be rewarded by relatively strong share price performance.
Chris Iggo is the chief investment officer for core investments with AXA Investment Managers