Outlook 2023: Institutions ponder stagflation investing
Inflation. Recession. Stagflation.
All these topics will be top of mind for institutional investors as the world heads into 2023.
Investor sentiment seems cautious for the first half of the year, with growing expectations the developed world may be close to an interest rate cycle peak or at least a slowing in the pace of rate hikes.
Yet inflation – the big story of 2022 – is likely to persist in 2023 and will prompt some asset owners to diversify into real assets to secure returns, while others could look at tactical plays.
“Though the uncertainty revolving around international markets continues to be a strong concern, we are taking a ‘cautiously optimistic’ stance as we are not ignoring indicators that may suggest improvement in the macroeconomic outlook such as the possible peak in global inflation and the Fed’s hints that interest rate increases will begin to slow in the coming months,” Seri Amir Hamzah, CEO of Malaysia’s $217 billion Employee Provident Fund said when the fund released its nine-months results in early December.
Still, the first half of 2023 will be a very difficult and volatile period for investment, as the risk of stagflation – stagnating growth coupled with persistent inflationary pressures – will mount, Chi Lo, senior investment strategist Asia Pacific at BNP Paribas Asset Management told AsianInvestor.
BNP Paribas AM
While the US Federal Reserve may slow its pace of interest rate hikes, inflation remains much higher than central bank targets, which means central banks are not yet done with raising rates even as economies slip into recessionary territory under the weight of monetary policy tightening, said Lo.
“Stagflation will squeeze margins, raise capital costs, trigger earnings downgrades and cause market sell-offs.”
Monetary policy will continue to be the key driver of asset prices in the developed world in 2023 – something that asset owners in Asia will be mindful of as they mull overseas investments.
Central banks in the developed world have hiked interest rates by roughly 2-4 percentage points each – at the fastest pace in the past 40 years, a Northern Trust note dated December 13 said.
“Our base case scenario is for Europe to slip into recession given its greater exposure to elevated energy prices, for the US to slow down meaningfully and for emerging markets to remain troubled by China’s struggles,” the report said.
While the combination of interest rate hikes and slower growth has started to push down inflation, developed markets are not necessarily at the end of the cycle, the Northern Trust report said.
The US federal funds rate could peak at the target 4.5%-4.75% range in the first quarter of 2023, according to Keith Wade, chief economist and strategist at Schroders. “It could prelude interest rate cuts later in the year as the recession deepens,” Wade said in a note dated December 13.
Schroders expects a 1% decline in US GDP to track through to a 14% drop in US corporate profits in 2023. “However, valuations begin to recover due to central banks cutting interest rates in response to the worsening growth and improving inflation landscape,” Wade noted.
No other major economy except the US is expected to pivot to ‘rate cuts’ in 2023, Wade added.
Still, while moderating inflationary pressures may warrant a pause in tightening in early-to-mid 2023, a reversal in monetary policy — much less a move back toward pre-2022 monetary policy settings — is unlikely, as the Northern Trust report notes.
Providing a moderate boost to investor sentiment is China’s recent policy easing measures and relaxation of Covid-19 restrictions.
“While that is good news for the medium term, in the near term everyone could hunker down [as Covid-19 cases surge] and that could further disrupt the supply chain and add to inflationary pressures around the world,” said Daniel McCormack, head of research, Macquarie Asset Management (MAM).
Still, McCormack expects inflation to fall around the world, and in the developed world in particular. "While the supply chain disruption could indeed add to inflation at the margin, it won’t be enough to stop inflation falling over the next six months or so," he told AsianInvestor.
The overall situation should improve after the National People’s Congress convention in March, as more property easing measures come through, McCormack said.
Asset manager sentiment towards Asia has also changed markedly in recent weeks, driven by China. “According to our December BofA Asia Fund Manager Survey, majority of the participants now expect the regional economy to strengthen over the next 12 months, on the back of an expected recovery in China,” Ritesh Samadhiya, Asia and GEMs equity strategist, at BofA Securities, told AsianInvestor.
Still, BNP Paribas’ Lo cautions that China’s reopening will not necessarily make up for the developed world’s slowdown. “China’s recovery is expected in the second half of 2023, but the developed market’s recession has already started. This implies there is a global demand vacuum in the coming six months.”
REAL ASSETS, CURRENCY PLAYS
Given that some asset owners are starting to think inflation may be at or near peak levels, they could be on the lookout for asset classes that could gain from a slowing of inflation.
Historically, equities would benefit from such a decline in prices, as might long-dated bonds as well as high-yield bonds and credits, said Martin Sanders, head of pension investments at AXA IM Core in a Pensions Investment Outlook 2023 released December 1.
Defined contribution pension funds might add more equities as they rebalance their portfolios but that is not without its own risks. “With recessions looming, valuations could well come down first before equities recover. In the meantime, we have seen that pension funds have been looking to add inflation-linked bonds,” he said.
Other asset allocators are diversifying their portfolios into real assets such as property and infrastructure to protect capital and secure higher returns.
Australia's A$200 billion ($134.28 billion) sovereign wealth fund, for instance, is increasing exposure to gold, commodities, infrastructure as it believes the world will see a repeat of the low-growth, high-inflation era of the 1970s.
Macro themes, tactical strategies and long-term structural drivers could throw up some interesting opportunities for long-term investors, said MAM's McCormack.
“Structural themes could include demographics, digitalisation, decarbonisation, McCormack said.
Currency markets could be another source of opportunity, with the US dollar likely to trend lower against major currencies over the next six to 12 months, according to Standard Chartered Wealth Management Chief Investment Office.
The Federal Reserve’s ‘pause’ in the rate hiking cycle will be the key catalyst, it said in its Outlook 2023 report.