Higher interest rates put pressure on valuations during 2022, but the focus will now shift from valuations to corporate earnings in an increasingly challenging macro environment.
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International Macro Scenario
Conservative projections, with risks of a "mild global recession" this year.
Projected Global Growth 2023: 2.3%, Projected Developed Growth 2023: 1.1%, and Projected Emerging Growth 2023: 3.8%.
The reopening in China may help offset weakness in developed markets, but could also put pressure on inflation expectations.
Base scenario 2023 inflation: the year will continue to be inflationary, but at a more moderate pace (around 4.0% for the US).
Monetary policy: a slower pace but a higher peak (terminal rate above 5.0% and no cuts in 2023 in the case of the Fed).
Financial conditions have been easing, which conspires with the objective of keeping inflation expectations well anchored.
Real economy data show an increasing probability of recession, albeit limited in key asset prices.
International Equities
The focus will shift from valuation to earnings in 2023.
Much of the equity adjustment during 2022 can still be attributed to "multiple compression" on account of higher interest rates stemming from inflationary pressures, while corporate earnings expectations remained relatively resilient.
Looking ahead to 2023, the focus will shift from valuations to earnings. It all remains a delicate balance between lower inflation and rate pressures versus deteriorating earnings prospects.
The level of rates limits the expansion of multiples. Dividends and FX return will be the most relevant factors to explain the performance of equity markets.
Overweight ex-US markets in tactical terms. Trend fed by the weakness of the dollar and the reopening in China. Valuations are more attractive outside the US.
In terms of sectors and styles, we continue to overweight value sectors over Growth.
In the case of the US, our projections suggest that equities are trading at fair value levels (around 4,000 points for the S&P 500), which may be overstated, but limits the potential for further recovery, as both absolute and relative valuations relative to bonds are not particularly attractive.
Earnings are beginning to correct further downward, given a more challenging corporate macro environment heading into 2023.
Equities, particularly US equities, do not incorporate a recession.
International fixed income
As inflationary pressures begin to moderate, an intermediate step in risk taking should be via investment grade fixed income.
The cooling of U.S. inflation argues for a reduction in the pace of hikes, not yield levels.
Negative slope, neutral in duration (around 4 years).
Overweight IG US. Things are starting to look more attractive in the bond market. IG debt in the US today offers a rate of 5.0%, the highest level in 15 years. In a recession scenario, the fall in basis more than offsets the potential rise in spreads, which is not the case for HY debt.
Regarding Corporate Spreads, the risk-return relationship is not attractive, especially in high yield debt.
US fixed income incorporates low recession risk.
Dollar and commodities
Less dollar, more commodities
Rate differentials become less favorable toward the dollar given the expected larger drop in US rates.
Just as commodity markets were dominated by the dollar in 2022, they are expected to be determined by underinvestment in 2023. From a fundamental perspective, the setup for most commodities in 2023 is bullish.
Alternative assets
Why can bad news be good news for alternative assets?
Structurally higher inflation, where Central Banks will raise and/or maintain higher interest rates for longer, and where the world seems to revolve around one Central Bank: the FED.
This will generate more volatility at the macro level, as a result of monetary policy responses that may be surprising. The difference in the aggressiveness of Central Banks will generate volatility in exchange rates and asset values.
As a consequence of this environment, fundamentals are more important than ever, asset selection becomes more relevant and portfolios should focus on diversification and alpha rather than beta.
In this environment, unlike the previous decade, capital is going to be scarcer, so there will be opportunities in the private markets, both financing and equity, with current vintages likely to have better than average returns.
Opportunity as a 60/40 portfolio diversifier, volatility reduction, increased flow or uncorrelatedness.
