Elevated valuations now make it more difficult for us to argue that markets are appropriately priced for the slowdown we still see ahead.
Our macro “base case” on a 12-month horizon is little changed from the year ahead outlook, although elevated valuations now make it more difficult for us to argue that markets are appropriately priced for the slowdown we still see ahead. The path of inflation is the key difference between our two downside scenarios. In one, falling inflation prompts rate cuts and enables bonds to act as diversifiers, while in the other, sticky inflation is likely to see the price of stocks and bonds falling together.
Macro: Fading business and consumer spending tips developed economies into mild recessions. Labour market hoarding keeps unemployment rates relatively low, but cooling wage growth helps to gradually ease core inflation pressures, allowing the central banks to pause. China’s post-Covid recovery continues in the services sector but weak business investment continues to drag on growth. The Fed pauses its hiking cycle with rates below 5.5%, while for the Bank of England (BoE) and the European Central Bank (ECB), hiking cycles pause with rates at around 5% and 4% respectively. Rate cuts don’t start until 2024, and are modest when they do arrive.
Fixed income: Government bond yields range bound. Investment-grade (IG) credit spreads remain well behaved, high yield (HY) credit spreads widen as default rates rise gradually towards long-term averages.
Equities: Challenging environment for stocks with elevated volatility and muted total returns. Higher quality stocks outperform and DM ex-US leads US given higher dividend yields and cheaper valuations.
Currencies: USD modestly weakens on a trade-weighted basis. JPY strengthens as yield curve control is removed, while EUR is supported by a degree of convergence on growth and interest rates.
Alternatives: Real assets provide income and some inflation protection. Hedge funds benefit from higher equity market volatility.
Macro: Developed market growth slows sharply, pushing economies into deeper recessions. Weakening labour markets, lower commodity prices and rapidly falling inflation force central banks to aggressively cut rates. China’s post-Covid recovery stumbles, prompting more monetary stimulus. The Fed begins a substantial rate cutting cycle in the autumn. The ECB and the BoE continue to hike this summer but then are forced to U-turn abruptly, and also begin cutting later in 2023.
Fixed income: Government bond yields fall, with yield curves re-steepening. IG spreads widen modestly and HY spreads widen sharply, but falling government bond yields help to dampen total returns.
Equities: Negative total returns for stocks, but without testing lows seen last October. Earnings are hit hard, higher quality stocks outperform and Growth outperforms Value. US leads DM ex-US given Growth tilt, while emerging markets underperform developed market counterparts.
Currencies: USD and JPY strengthen against cyclical currencies due to safe-haven flows.
Alternatives: Commodities struggle, real estate challenged, hedge funds benefit from higher vol (but bonds are the most effective diversifier).
Macro: A combination of consumer resilience and extremely tight labour markets keep core inflation sticky. China’s recovery gathers steam, putting upward pressure on commodity prices. The Fed and the BoE both hike rates towards 6%, and the ECB hikes past 4.5%. Higher rates force more things to break in the economy, but central banks maintain “higher for longer” rates given stubborn price pressures.
Fixed income: Bonds fail as diversifiers, with front-end government bond yields rising to reflect both a higher terminal rate and the pricing out of rate cuts. IG spreads widen given growth slowdown and HY spreads widen sharply in anticipation of default rates rising above long-term averages.
Equities: Short-term earnings resilience is offset by valuations falling leading to negative total returns, as markets anticipate central banks having to deliver a deeper downturn. Quality outperforms. US underperforms DM ex-US given larger hit to valuations.
Currencies: USD strengthens against cyclical currencies as risk-off leads to safe haven flows.
Alternatives: Real assets outperform given inflation protection and hedge funds benefit from higher volatility. Private equity and private credit come under pressure.
Macro: Growth remains resilient while inflation cools, as a boost to labour supply eases wage growth despite no increase in unemployment and base effects drag the rest of the inflation basket lower. China’s recovery gathers pace as business investment accelerates, but without creating major upside to commodity prices. Central banks deliver on current market pricing for rate cutting cycles, as lower inflation allows rates to return to neutral levels.
Fixed income: Government bond yields fall modestly. Credit outperforms rates and HY outperforms IG as spreads tighten across all credit sectors. Great environment for EMD.
Equities: Best outcome for stocks. Earnings expectations rise as markets look through to 2024 re-acceleration, and valuations continue to rebound. Higher quality stocks underperform, and cyclicals outperform defensives.
Currencies: USD weakens on a trade-weighted basis.
Alternatives: Real assets provide income and capital appreciation given lower rates. Hedge fund performance is sluggish amid low volatility.