Market Outlook: Is the worst really over for the stock market?

• Not too long ago, a global recession felt inevitable. Now, investors increasingly believe that a “soft landing” that quashes inflation without engineering a recession can be achieved.

• A global recession is unavoidable in 2023. With the impact of higher interest rates yet to be felt fully, the drag on economic activity will intensify in the quarters ahead.

• Inflation may prove more persistent than expected even if recession comes. Besides, rarely has inflation fallen that much, so quickly. Even if it did, the process was not without pain.

• Even though a bullish consensus is emerging for Chinese equities, we prefer to remain cautious as we believe the recent rally is unlikely to last.

• We believe 2023 is shaping up to be yet another challenging year, with a stagflationary environment warranting a more defensive positioning in our asset allocation.

Markets have suffered in 2022 under a toxic combination of rising interest rates and high inflation. So far, 2023 has been markedly different. Even amidst concerns over an economic slowdown, investors have greeted the Year of the Rabbit with much fanfare, with global equities rising 5.2% in the first month of this year (in SGD terms as of 31 January 2023).

Many indices, including Europe’s Stoxx 600 Index and Hong Kong’s Hang Seng Index, have seen their best start to the year in decades. The S&P 500 Index is up by 4.3%, while the NASDAQ 100 Index, which lost more than one-third of its value last year, has roared back with stunning gains of 8.6%. China has now entered a bull market.

Not too long ago, a global recession felt inevitable. Now, investors increasingly believe that a “soft landing” that quashes inflation without engineering a recession can be achieved. A better-than-expected 4Q GDP data, which indicated the US economy finished 2022 in solid shape, also added to the optimism. Meanwhile, inflation has moderated in recent times, giving investors hope that the Fed could pivot to rate cuts later in the year in response to recessionary conditions. China’s reopening has also been welcomed by investors as a likely boost to global growth.

Could the global economy really avoid a recession? Could inflation really be brought down to 2% without much economic pain? Could China really pull off a quick and strong economic recovery that investors have all been hoping for? Is the worst really over for global equity markets?

Hold your horses. It is too soon to declare an end to the global economy’s problems.

Recession will likely be unavoidable

Looking ahead, we see a challenging macroeconomic environment.

Start with the bad news: a global recession is unavoidable in 2023. Over the past five decades, whenever inflation rises above 5%, it has always taken a recession to bring it down. It will not be any different this time. It is only when growth is negative can inflation be finally contained.

Furthermore, the Fed is not alone in tightening monetary policy. With inflation at multi-decade highs in many countries, central banks across the world have been tightening over the course of 2022 in a concerted effort to curb inflation. This global monetary tightening is now increasingly synchronised around the world, with nearly every major economy jamming on the brakes. Policy has never tilted so overwhelmingly towards rate rises in the past five decades (Chart 1). The last time this happened, the outcome was a global recession.

Chart 1: The simultaneous tightening of monetary policies globally has been unprecedented

While the US economy grew at a faster-than-expected pace in 4Q 2022, it was largely due to a build-up in inventories and a narrowing of the trade deficit, both of which are often volatile categories and are not sustainable sources of growth. With the impact of higher interest rates yet to be felt fully, the drag on economic activity will intensify in the quarters ahead.

Consumer expenditures, the bulwark of the economy, are showing signs of weakness. Retail sales in the US fell a seasonally-adjusted -1.1% in December from the prior month, the largest monthly decline in 2022, as consumers cut back at the peak of the holiday season amidst rising interest rates, still-high inflation, and concerns over a slowing economy. Manufacturing output has also tumbled sharply in the same month. Meanwhile, leading indicators also suggest that a recession is nigh (Chart 2).

Chart 2: Leading economic indicators are signalling a slowdown ahead

There should be little doubt that the world is heading towards a recession.

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Even a recession will not bring down inflation

Yet, inflation may still prove more persistent than expected even if a recession comes.

For now, inflation in the US is slowing. In December, the headline US consumer price index (CPI) rose 6.5% year-on-year, down from 7.1% in November – the sixth straight month of decline – thanks to falling energy prices and easing supply chain disruptions. Wage growth also slowed further in the same month, adding to signs that inflation is now on a sustained downward trend.

Unsurprisingly, hopes for a quick return to 2% inflation have increased. As of 31 January 2023, US Treasury notes maturing in January 2024 were yielding around 4.67%, while inflation-protected Treasuries maturing in the same month were yielding about 2.66%. The difference between the two figures, called the break-even inflation rate, suggests that investors are betting inflation will rise by about 2% over the next 12 months.

They could be disappointed. As inflation slows, it will get harder to fight.

For a start, there is still a continued scarcity of workers in the labour market. As the global economy heads for a recession, some increase in unemployment seems inevitable, but shortages in labour markets are so acute that the demand for labour has a long way to fall before it matches supply.

In the US, there are now close to two vacancies for every person currently registered as unemployed (Chart 3). The unemployment rate is also back at a five-decade low of 3.5% in December 2022. Wages in December were 4.6% higher than a year ago, still above the 3.5% that would be consistent with the Fed's 2% inflation target. With labour costs accounting for about two-thirds of the CPI, a tight labour market could continue to exert upward pressure on inflation.

Chart 3: Demand for labour in the US remains high

Furthermore, energy inflation could make a comeback in 2023. While energy prices have been falling in recent times, contributing to the current bout of disinflation, there are no assurances that energy prices will remain where they are throughout 2023, particularly as China reopens its economy. It is worth noting that China consumes almost one-fifth of the world’s oil, over half of refined copper, nickel and zinc, and more than three-fifths of iron ore. It is also the world’s largest consumer of agricultural goods. With China’s economy under lockdowns for most parts of 2022, a reopening could accelerate upward momentum for commodity demand and prices.

Finally, as we’ve been highlighting in previous articles, we believe that inflation is structural. The world is moving into a new regime where structural forces will lead to a more persistent rise in inflation in the years ahead. Inflation in the decade ahead will broadly be driven by three factors: (1) supply-driven shortages in commodity markets, (2) structural changes in labour markets, including an ageing population and a broader decline in immigration, as well as (3) deglobalisation.

All of this means that a recession would not be sufficient in itself to bring down inflation and that we are still some way off in achieving the Fed’s 2% inflation target.

Some perspective is helpful. Based on historical data, inflation across advanced economies has taken an average of 10 years to return to 2% once it breaks above 5%, according to Bank of America. If inflation indeed falls as fast as markets are now forecasting, it will be even faster than when Paul Volcker crushed soaring inflation in the 1980s with double-digit interest rates, an episode that ultimately culminated in a serious recession.

Rarely has inflation fallen that much, so quickly. Even if it did, the process was not without pain.

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Still unconvinced with Chinese equities

The rally in Chinese equities has been relentless. Over the past three months, the MSCI China Index has surged by a monstrous 41.7%, while the Hang Seng Tech Index has also jumped by an impressive 48.3% (in SGD terms as of 31 January 2023). Even though a bullish consensus is emerging for Chinese equities, we prefer to remain cautious as we believe the recent rally is unlikely to last.

Firstly, China’s recovery will not be linear. China’s current Covid-19 wave has so far been confined to the urban areas, with rural areas remaining largely unscathed. This is about to change. With millions of people travelling back to their hometowns for Chinese New Year, the virus will likely spread to the rural areas, where many people are elderly, immunisation rates are lower than in cities, and healthcare systems are even less prepared to handle an expected surge in infections. An even bigger Covid-19 wave appears inevitable, causing short-term disruptions to the economy.

Already, hospitals and financial institutions have been reportedly battling staff shortages, with workers calling in sick after contracting the virus. Factory activity – China’s traditional engine of growth – contracted for the third straight month in December and at the sharpest pace in nearly three years as infections swept through production lines across the country, with many factory workers and truck drivers down with Covid-19. As a result, many manufacturers have been operating way below their capacity, and have been forced to delay or cancel their orders.

Even if the current wave dies down, China’s reopening is ill-timed. The dismantling of its zero-Covid policy comes at a time when the rest of the world is slowing down. By the time this wave ends, the US and Europe could already be in a recession. As such, China’s exports will likely face headwinds in the year ahead. Consumers will have to come out in full force to spend in order to pick up the slack left behind by its exports industry.

At this point, it remains unclear if consumption will indeed rebound strongly. Consumer confidence remains fragile, especially with youth unemployment remaining chronically high at near 20% and the ongoing crisis in the property market sapping confidence. The possibility of subsequent waves and the emergence of new variants could also derail the recovery.

There are also lingering long-term issues. China’s shift to a top-down state-controlled economy could usher in a low-growth period and imperil the long-term profitability of private companies. The risk of policy mistakes will also be higher. China’s foreign policy stance will likely be more assertive, with President Xi steering China’s away from reconciliation with the West and increasingly adopting a harder line against Taiwan, ushering in a dangerous new era of hostility between the US and China.

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Asset allocation moving forward

Is the worst really over for global equity markets? Apparently not.

Behind this year’s improved start for markets lies an assumption that central banks will engineer a Goldilocks scenario of “soft landing” – an ideal outcome in which soaring inflation is brought back to 2% without tipping the economy into a major downturn. Everything would have to go right for this to happen. It will be a difficult feat.

We believe 2023 is shaping up to be yet another challenging year, with a stagflationary environment warranting a more defensive positioning in our asset allocation.

At the asset class level, we retain our preference for fixed income over equities, as we are starting to see attractive value emerging within this asset class, with global bond yields climbing to levels that were last seen during the global financial crisis. The valuations of bonds have also turned much more attractive as compared to equities, as seen from the tightening spread between earnings and bond yields (Chart 4). The downside risks to corporate earnings also warrant a defensive positioning.

Chart 4: Bonds are increasingly more attractive compared to equities

Within fixed income, we prefer investment-grade over high yield as a more defensive positioning may be more important in a recessionary environment. In terms of duration, our preference is for short-duration bonds as short-term bond yields have moved significantly higher as compared to long-term yields. An unconstrained bond strategy is also viable as it allows for better management of interest rate risk in this tough environment.

Within equities, developed markets now look more attractive relative to emerging markets. In particular, we prefer the US and Japan. Furthermore, given our expectations that inflation is likely going to be higher for longer, value stocks and commodity-linked equities will be amongst the winners. We also favour Latin America and ASEAN equities. ASEAN, in particular, is poised to benefit from the shift of production away from China.

While India may benefit from a less constructive outlook for China as investors rotate into Indian equities within emerging markets, its lofty valuations mean that now may not be the right time to invest in India. We urge investors to have Indian equities on their watch list and wait for valuations to become more palatable before entering the market.

Lastly, we believe the USD is likely overvalued after its sharp rise in 2022. Investors should consider hedging away their USD exposure where possible, opting for hedged share classes for products exposed to the USD. We also expect the Japanese yen to reverse higher in 2023 after a significant weakening last year.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.