Markets Weekly podcast – 16 January 2023
In this week’s podcast, Dorothée Deck, our Cross Asset Strategist, explores the prospect of a global recession in 2023. Tune in as she reflects on long-term structural trends and possible opportunities in the defensive space. Host Henk Potts also considers this year’s strong start for equity markets, US inflation and the latest economic data from Europe.
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Henk Potts (HP): Hello. It’s Monday, 16th January 2023 and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.
My name is Henk Potts, Market Strategist with Barclays Private Bank. Each week, I’ll be joined by guests to discuss both risks and opportunities for investors.
Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then discuss how investors should be positioned from an equity market perspective during the course of this year and beyond. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
The impressive start to the year for risk assets continued last week, on hopes that a material moderation inflation will occur as the year progresses. The end of the aggressive rate-hiking cycle is now within sight, and policymakers can, indeed, orchestrate a softer economic landing.
China’s rapid reopening should also boost domestic activity in the world’s second-largest economy and ease global supply-chain constraints. So, after a miserable 2022, equity markets have rallied aggressively since the start of the year. In fact, European stocks have registered their best start to the year on record. The STOXX 600 is up a stunning 6.5% in the first two weeks of trading.
Over on Wall Street, the S&P 500 closed less than one point below the 4,000 level and was up 2.7% during the course of last week, its best week since the week commencing 6th November. The benchmark index is up 4.16% year to date.
In bond markets, well, yields continue to ease back. Ten-year Treasury yield has fallen 0.31 percentage points over the course of the last two weeks, the largest two-week decline since the week ending 18th November. It was off 0.72 percentage points from that 52-week high of 4.2%. Remember, that was hit back on 24th October.
Surging price pressures have undermined the stability of the economy, forced policymakers to aggressively hike rates and negatively impacted real incomes, all of which has weighed on investor sentiment. Markets are, as we said, desperate to see confirmation that price pressures are easing. Therefore, Thursday’s US CPI print was seen as an important step in the journey to a more stable economic environment.
US inflation declined one-tenth of 1% month-on-month in December. That’s the first decline in two and a half years. While 6.5% year-on-year is still elevated, remember, that’s more than three times the target level. Price pressures have been decelerating for six-straight months, after peaking at 9.1% in June, and are now at their lowest level since October 2021.
Headline inflation was dragged down by that 9.4% fall in energy costs. Goods inflation declined. Food inflation decelerated. Economists, as we know, are closely watching core inflation, which strips out volatile food and energy components. Here, the progress, you have to suggest, has been less pronounced. Core inflation continued to increase. It was up three-tenths of 1% month-on-month, 5.7% year-on-year as shelter costs continue to rise and overpower deflationary goods.
The dialling down of price pressures is a trend that we’d expect to continue and will be welcomed by policymakers. That adds to the evidence they’ll be able to complete the hiking cycle in the coming few months.
We now forecast the US hiking cycle will be concluded with a series of 25-basis point increases in February, March and May, after which we anticipate the central bank will maintain the policy rate of 5% to 5.25% through much of the year, then towards the very end of this year, we do see the potential for a pivot to an easing stance as inflation continues to moderate, the US labour market cools and growth weakens. We have 25-basis point cuts pencilled in for November and December of this year.
Moving on the UK, where the economy defied negative predictions and managed to eke out growth of 0.1% in November. Economists had predicted a contraction of 0.2%. The service sector grew by two-tenths of 1% on the month which drove the gain in activity, with the largest contribution to growth coming from food and beverage activities boosted by demand during the course of the World Cup, though demand is still in that sector 8.5% below the February 2020 level.
The reading suggests the UK economy may now avoid recording a second quarter of contraction in Q4 following that 0.3% decline in output registered in the third quarter. However, the outlook still remains negative with consumption weakening, manufacturing PMI in contraction territory and recovery in the service sector showing further signs of fizzling out.
Consumer demand is expected to come under further pressure as households, of course, confront a plethora of pressures including higher interest rates, rising energy bills and elevated and persistent levels of inflation.
UK inflation is forecast to moderate at a slower pace than other advanced economies due to the impact of higher energy bills, lower levels of government assistance and the ongoing disruption to the supply of labour and goods. We forecast UK CPI will average 7.9% during the course of this year and remain above that 2% target level till the end of 2024. Therefore, we predict three further hikes by the Monetary Policy Committee with a 50-basis point increase in February, followed by 25-basis point hikes in March and May, which will make the terminal rate for UK base rates at 4.5%.
Given the multitude of pressures on the UK economy, a recession is now predicted. The UK economy contracting for the first three quarters of this year. We forecast the recession will generate a peak-to-trough decline of 1%. Calendar year 2023, we predict real GDP will contract by seven-tenths of 1% followed by an only sluggish recovery in 2024 of 0.4%.
So, that was the global economy and financial markets last week. In order to discuss the prospect for equity markets, I’m pleased to be joined by Dorothée Deck, Cross Asset Class Strategist with Barclays Private Bank.
Dorothée, great to have you with us today. The consensus view amongst economists is that we’ll see some level of global recession during the course of this year. However, we’ve already seen a substantial fall in equity markets from the peak levels of January last year, so, surely, some of those risks must already be factored in. So, the question is, how much more downside risk do you see from the current levels if the macro environment does not pan out in the way that we’ve been talking about, ie that mild, shallow recession?
Dorothée Deck (DD): Good morning, Henk. Good to be with you. So, at current levels, the markets seem to be discounting a mild recession, which is in line with our base-case scenario. Anything worse than a mild recession would obviously have negative implications for markets.
So, we looked at what normally happens during a recession and compared it with what is currently discounted by the market, and our conclusion is that following the strong start to the year there could be a 20% downside risk to global equity prices from current levels if a more typical recession materialises. So, that would take us below the October lows and about 33% below the peak levels of January last year.
To be clear, this is not our central case. This is based on the assumption that the ISM manufacturing index declines to around 39, in line with its average trough in previous recessions, and it also assumes a 20% contraction in corporate profits.
HP: OK, Dorothée, that’s the negative scenario that could potentially play out. What would you like to see to turn more positive on markets?
DD: So, generally, we’d like to see a combination of cheap valuations, depressed sentiments, cautious positioning and also a sense that we’ve seen the worst in terms of economic activity, inflation and rates. If I look at where we are today, equity valuations have already plunged on the back of the surge in real yields. However, sentiment and positioning are no longer extreme. They’re mildly negative, but they have significantly improved from their October lows.
Equity allocations amongst individual investors remain high relative to history and consumer sentiment, especially considering that a recession is looming, and risk appetite measures across major asset classes are back to neutral. With regards to macro, inflation seems to have peaked but remains well above central banks’ targets.
Economic activity continues to deteriorate and policy rates haven’t peaked, so we do not think that the conditions are in place yet for a sustainable rebound in markets. For markets to look beyond this period of uncertainty, we will need to see clear signs that economic activity has dropped and that central banks’ hiking cycle has come to an end, because, historically, rate cuts have been a key catalyst for equities to rebound.
HP: OK. Let’s try and bring those concepts together. What does this mean for markets, at least in the short term, and how should investors be positioned for that environment?
DD: So, given the macro uncertainty on geopolitical risks, clearly, volatility is here to stay, with risks tilted to the downside. Until we get more clarity on the growth and inflation front, markets are likely to be very myopic and trade on headlines. So, basically, we expect markets to continue to oscillate between risk-on and risk-off periods in a wide range.
During this time of uncertainty, price action is likely to be driven by news flow around activity on inflation surprises, labour market developments and central bank commentaries, and we could continue to see those sharp rallies and violent rotations that we’ve seen in the past year. In that context, selectivity will be key and we would encourage investors to keep hedges in place and use option strategies where possible to reduce downside risk.
But I’d like to stress that despite those risks in the near term, the long-term prospects for equity investors have significantly improved in recent months. So, historically, cyclically adjusted PEs have been reliable indicators of long-term expected returns and at current levels they are consistent with global equity returns of 8.5%, annualised, over the next 10 years, including dividends, and that’s broadly in line with the returns generated over the past 20 years.
HP: Dorothée, when we look at the price action over the course of the past year it would certainly be an understatement to say that 2022 was a volatile year. Global equities, as we know, were down almost 20%, but certainly not in a straight line. We had a series of sharp rallies and violent rotations which surprised, I guess, a number of investors. How do you see 2023 playing out, and where do you see the opportunities at a sector and regional level?
DD: So, rates are likely to be higher for longer, so we expect a continuation of the trend of the past few months where equity performance has been very much driven by the stock sensitivities to real yields as well as their valuations. The stocks that have underperformed the most in the past year are the ones that have been most negatively correlated with the level of yields, ie the long-duration stocks and also the most expensive parts of the markets.
The worst-performing sectors have been tech, communication services and consumer discretionary. At the style level, value outperformed growth by over 30% last year, but despite this very strong performance value versus growth has significantly lagged the surge in real yields which means that even if yields stabilise at current levels, there is still room for value to outperform further. In addition, value continues to trade at a significant discount to growth compared to history. At the sector level, this translates into a positive view on banks and energy.
So, if I start with banks, their relative performance has also significantly lagged the rise in yields due to their sensitivity to the business cycle as the macro outlook deteriorates. However, banks are much better prepared today for the next downturn than they were in the last crisis, and if rates are going to be higher for longer, they should be one of the main beneficiaries. Valuations, dividend yield and earnings revisions are also supportive.
With regards to the energy sector, it should continue to benefit from high energy prices, which are supported by tight supplies, and it also represents a good hedge against inflation and geopolitical risk. The sector has already performed exceptionally well. It was up close to 50% last year while the broader market was down 18%. However, it continues to trade at a significant discount to the market and offers a superior dividend yield.
And at the regional level, we particularly like the UK market for its favourable sector composition and attractive valuation. It has a value tilt with an overweight exposure to financials, energy and basic materials, and an underweight exposure to technology. Valuations are very compelling and sentiment is depressed.
HP: So, if I tried to characterise those opportunities which you’ve just highlighted, it appears that they are mainly driven by a dislocation in markets or trying to capitalise on some of those long-term structural trends. Do you see any attractive opportunities in the defensive space? This is for investors particularly wanting to reduce risk within their portfolios.
DD: So, unlike some of our peers, we would not chase defensive sectors at current levels, because we think that they’re very expensive as a group. Attractive opportunities can still be found at the stock level, but defensive sectors as a group are now trading at an extreme valuation premium versus cyclicals, ie close to 2.5 standard deviations above their 20-year average. Instead, we would rather increase defensiveness in multi-asset portfolios via the fixed income market at present.
Following the substantial increase in rates in the past few months, fixed income markets, and credit in particular, now offer an attractive alternative to equities. The lack of alternative which has prevailed for most of the past 10 years pushed investors up the risk curve into equities. However, the gap between global equities’ dividend yield and US 10-year bond yields is now the most negative it’s been in the past 12 years, despite higher risks. And, similarly, the gap between dividend yields and investment grade corporate bond yields is now the most negative since 2008.
If we look at relative valuations, and more specifically the de-trended bond yield to earnings yield ratio, it has now reached an extreme level which in the past has been associated with a rotation out of stocks into bonds. So, as the market focus shifts from inflation to recession, stocks are likely to underperform bonds in the coming months. Sovereign bonds and corporate credit generally outperform equities during recession.
Now, if we take a step back and focus on the long term instead, we continue to favour equities over bonds over a 10-year horizon. Using history as a guide, cyclically adjusted PE suggests that global stocks could outperform bonds by about 4% in the next 10 years. That’s below the 5% outperformance seen in the past two decades, but that’s a substantial improvement from the 1% implied at the start of last year when equity valuations were much higher.
HP: Well, thank you, Dorothée, for your insight today. Whilst 2023 is expected to be another challenging year for the global economy, I think it is right to highlight those risks along with the possible implications for asset prices. We should appreciate that considerable amount of bad news is already priced in and there continues to be both short-term and long-term opportunities to consider while appreciating that risk should be taken as part of a balanced diversified portfolio.
Let’s move on to the week ahead where the focus will stay on the UK with labour market data on Tuesday and inflation numbers on Wednesday. We expect unemployment for the three months to November to move sideways at 3.7%, and the headline average weekly earnings to accelerate further to 6.2% year-on-year. In line with a gradual loosening in labour market conditions, we expect vacancies to continue to drift lower, albeit they’re likely to remain at elevated levels.
We expect December headline UK CPI to print at plus three-tenths of 1% month-on-month, 10.5% year-on-year, and core CPI to print at 0.4% month-on-month, 6.2% year-on-year. This would constitute a second consecutive month of decline in the year-on-year rate for both headline and core inflation, and would support the case that October was the peak for both measures.
Downward contributions to the change in the annual rate are likely to come from energy and goods, which we expect to be partially offset by upward contributions from services and food.
In the US, we await Wednesday’s retail sales numbers. Our indicators point to a weak minus 1.4% month-on-month reading for retail sales in December following November’s 0.6% month-on-month decline. Much of this reflects auto sales with light vehicle sales falling 5.2% in December. Excluding autos, we expect a four-tenths of 1% month-on-month decline. That’s on the heels of that 0.2% decrease that we saw in November. This reflects a soft forecast due to the hangover effect from sales pulled forward by October’s Amazon Prime Day sale.
With that, I’d like to thank you once again for joining us. I hope you’ve found this update interesting. We will, of course, be back next week with our next instalment. But, for now, may I wish you every success in the trading week ahead.
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