Navigating 2023, Markets Monthly Letter: When elephants dance

Equity outlook more balanced as recession risk recedes

In the first half of 2023, we saw two serious and acute risks to markets. As the Fed pressed ahead with the fastest rate hiking cycle since the 1980s, corporate profits were weakening and real wages were falling. But recently the outlook has been improving. Real wages are growing again, and corporate earnings have been stronger than expected.

We now have greater confidence that rate hikes will not cause a US recession over the next six months. Growth in China has disappointed, but not sufficiently to change the global picture. And weakness in China may even help reduce inflation in developed markets.

So how have these developments changed our investment views?

On equities, we now see a more balanced risk-reward outlook, and we move from least preferred to neutral. The second-quarter reporting season likely marked the trough in year-over-year earnings growth, and guidance for the third quarter was positive. We therefore now expect S&P 500 earnings per share to be flat in 2023 and rise 9% in 2024. Our base case targets for the index to reach 4,500 in December and 4,700 in June next year.

Despite the receding risk of a recession in the US, we still see a modestly higher profile for equities over the next six to 12 months, in our base case. Against this backdrop, we continue to favor laggards whose valuations are lower and have scope for a catch-up. We see more potential upside for emerging market equities than US equities, and keep our preference for equal-weighted US indexes compared to capitalization-weighted ones.

This month we upgrade the global energy sector to most preferred from neutral. The sector has lagged this year, but the improving economic backdrop, coupled with a tightening oil market, should support oil prices.

Fixed income remains our preferred asset class. Slower growth and falling inflation in our base case should be favorable for bonds, and yields are attractive in our view. We prefer high grade (government) and investment grade bonds, which offer attractive all-in yields and should be better placed than stocks if economic headwinds intensify.

This month we downgrade emerging market bonds from most preferred to neutral. These bonds have benefited not only from stronger global growth prospects but also a series of helpful idiosyncratic developments among distressed bond issuers, including countries like Egypt, Nigeria, and Pakistan. As a result, credit spreads are unlikely to tighten substantially further from current levels in our base case.

The US dollar remains vulnerable, in our view. We keep the US dollar least preferred and the euro most preferred. With inflation falling more quickly in the US than in Europe or the UK, we think it is more likely that the peak is near for US rates than for European rates, and the Fed may consider rate cuts sooner than other central banks. For the euro, we think negative economic surprises in the region are already priced into the currency’s valuation, and the Eurozone’s improving trade balance should be supportive.

Meanwhile, we move our view on the yen from most preferred to neutral. Given the relative strength of the US economy and the soft removal of Japan’s yield-curve control policy, we see limited catalysts that could outweigh the negative 5% carry that a long yen, short dollar position entails. Nonetheless, we continue to see a long yen position as an effective downside hedge, particularly if implemented using optionality.

So, with recession risks receding, in our view, the outlook for equity markets has improved. However, with valuations still demanding, we advise investors to focus on equity laggards, and we remain most preferred on fixed income, especially quality bonds.

Read more in our latest Monthly Letter, “ When elephants dance.”