We continue to recommend increasing the weighting of assets that are less sensitive to interest rates, such as cash, value stocks, international stocks, and real assets.
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International Macro Scenario
Recent data support a decline in the risk of a recession in the short term, as evidenced, for example, by PMI surveys, which show an improvement in orders complemented by rising employment and falling inflation, as well as by the fact that economic data across various regions have generally been surprising on the upside.
One scenario is a soft landing, in which economic growth slows but remains positive and inflation moderates, which would already be largely priced in.
U.S. inflation data, while continuing to show a moderation in year-over-year inflation readings, they also suggest that this moderation may be occurring more slowly than expected. Overall, what we continue to see is disinflation still concentrated in the goods market, but with services inflation remaining strong, as we await rental inflation to begin moderating later in the year.
In addition to consumer price data, producer prices came in higher than expected, retail sales for January were particularly strong, and labor market data remain solid. Simply put, economic data from recent weeks has mostly come in stronger than expected, reflecting an economy—and, in particular, demand—that remains quite resilient.
This has continued to put upward pressure on market rates (10-year Treasury yields are once again approaching 4%) and expectations for the terminal federal funds rate are now priced in at around 5.5%—that’s 50 basis points higher than just a few weeks ago. And for the first time in this cycle, the market is pricing in more rate hikes than the Federal Reserve, and options traders have been building positions with a target of 6% for September.
Some concerns have arisen regarding China's reopening process, so the government has called for stronger measures to boost domestic demand and investment.
International Equities
On Allocating to Non-U.S. Markets and Value Sectors
Much of the correction in the equity market during 2022 can still be attributed to a “valuation compression” resulting from higher interest rates driven by inflationary pressures, while corporate earnings expectations remained relatively resilient.
Looking ahead to 2023, the focus will shift from valuations to earnings. Everything remains a delicate balance between easing inflationary pressures and interest rates versus the deterioration of the earnings outlook.
Interest rates are limiting the expansion of multiples. Dividends and foreign exchange returns will be the most significant factors in explaining the performance of equity markets.
Earnings are beginning to show a downward trend (with the exception of China) given the more challenging corporate environment heading into 2023.
The recovery in equities—particularly in the U.S.—is not sustainable, with further downward revisions to expected earnings and higher interest rates putting pressure on valuations that are not particularly attractive.
In particular, the outperformance of growth sectors so far this year is unlikely to be sustainable, in a context of more persistent inflationary pressures and higher interest rates.
Tactically overweight non-U.S. markets. This trend is driven by the weak dollar and China’s reopening. Valuations are more attractive outside the U.S.
A good entry point for Chinese stocks, following the recent corrections.
International Fixed Income
Sovereign bond yields at the short end of the curve have become “quite competitive” compared to the yields offered by both equities and fixed-income securities.
The slowdown in U.S. inflation calls for a reduction in the pace of rate hikes, not in yield levels.
Negative yield curve, neutral duration (around 4 years). Increase duration as sovereign yields rise.
On Weighting U.S. IG. U.S. corporate bonds are attractive given their historically high initial yields. In a recessionary scenario, the decline in yields more than offsets the rise in spreads, which is not the case for high-yield debt.
Increase exposure to “cash.” Risk-free rates at the short end of the sovereign yield curve have become particularly attractive and can provide not only “yield” (1-year Treasury bills are already approaching 5%) and diversification, but also lower portfolio volatility, at a time when valuations in traditional assets are not particularly attractive.
With regard to corporate spreads, the risk-return profile is not attractive, especially for high-yield debt.
U.S. fixed income carries a low risk of recession.
The Dollar and Commodities
A weaker dollar, stronger commodities
Interest rate differentials are becoming less favorable for the dollar given the expected sharper decline in U.S. rates. While we acknowledge the progress made on inflation, it is still insufficient to dissuade the Fed from continuing to raise interest rates; therefore, after a 12% decline from its October highs, the dollar remains vulnerable to short-term rebounds.
Just as commodity markets have been dominated by the dollar in 2022, they are expected to be driven by a lack of investment in 2023. From a fundamental perspective, the outlook for most commodities in 2023 is bullish.
