THE GOOD NEWS BULLS
Q1 2023 – January
A healthy level of skepticism (or downright cynicism) is understandable following an onslaught of recent challenges. With a global pandemic, the outbreak of war in continental Europe, the evisceration of the so-called “central bank put” and an (apparently) imminent global recession, good news has been in short supply. The “glass is half-full” has rapidly gone out of fashion. While things can and do occasionally go from bad to worse, downtrodden sentiment can also provide a fertile environment for positive surprises.
An end to highly prohibitive lockdown measures in China was inevitable, as we discussed in the November 2022 Strategy Dashboard. What we (and financial markets at large) did not anticipate was the speed at which restrictions would be unwound. The rapid reversal means that the Chinese economy should recover quicker than expected and the release of pent-up demand should be more forceful in nature. This has strong implications not only for Chinese assets, which were broadly shunned in recent years, but also for global growth and recession risk. Europe in particular should enjoy a pick-up in export demand from the release of historically high Chinese household savings.
Speaking of Europe, Mother Nature has taken mercy on the continent. As nations raced to fill up natural gas storage ahead of the cold winter months, widespread concern mounted over the potential need for industrial sector energy rationing. We do not claim to have any expertise in the field of meteorology, although we did do a deep dive into historical weather patterns and corresponding variance in natural gas demand (don’t worry, we will stick to our day jobs). While Europe is not out of the woods yet with regards to future energy supply, the unusually mild winter experienced thus far has all but eliminated worst case scenarios for the time being.
On the more “conventional” economics front, recent US data has (for the most part) been encouraging, albeit less surprising. In the October 2022 Ask Forstrong we noted that the drivers of core inflation were ebbing and that would help take pressure off of the Federal Reserve to continue aggressively tightening monetary policy. This has largely played out as expected, with the Fed slowing down the pace of interest rate hikes, despite a resilient US labour market. This fading hawkishness has also helped take the steam out of the US dollar. Per the chart below, the trade-weighted dollar has plunged approximately 11% since late-September. Given its role as the world’s predominant trade and financing currency, a falling dollar is a welcome development for financial conditions abroad.
In the same October publication, we argued that the conditions for a durable stock market bottom had likely arrived. This has proved prescient, as risk assets have rallied strongly in the period since. But where to now? Undoubtedly, some of the excessive pessimism has been drained from the market, valuations have expanded and the headline challenges and risks have not disappeared. While pullbacks are possible and perhaps likely over the near-term, we would caution against selling into the rally just yet. Professional investor surveys reveal that cash and fixed income levels are still very high by historical standards; meaning many have not fully participated in the rally and there is still significant “dry powder” sitting on the sidelines.
CASH AND CURRENCIES
Widening interest rate differentials versus most major economies has propelled the trade-weighted US dollar to even loftier levels of overvaluation this year. As financial markets become increasingly convinced of a forthcoming pivot from the US Federal Reserve, the dollar is vulnerable to a reversal. US dollar exposure remains materially underweight in client portfolios.
A combination of fading growth and inflation would generally be considered a fertile environment for high quality government bond returns. Unfortunately, with an inverted yield curve in key markets such as Germany and the US, bonds have effectively discounted the macro tailwind and do not offer adequate compensation to extend duration. Fixed income positioning remains short duration and underweight.
Emerging markets (EM) equities had a challenging 2022, as global risk appetite contracted, most EM central banks battled inflationary pressure and China languished through lockdowns and property sector turmoil. Now, these factors have all peaked or are in the process of peaking in our view, making the asset class primed for re-rating. Overweight EM equity exposure has been increased in client portfolios.
US sub-investment grade bonds may seem like a counterintuitive asset class selection amidst an economic slowdown which will put upwards pressure on default rates. The combination of strong fundamentals, wide option-adjusted spreads and our view that the US economy will be more resilient than the consensus expects provides for a favourable outlook for returns. A position in US high yield bonds has been initiated in income-oriented strategies.