Goodbye 2022, here’s to the next 12 months
As always, financial markets are awash with attempts to explain what is going on and forecast what will happen next. Generally, most people struggle with the first, and fail miserably with the second. So, it is with great trepidation and humility that I look forward. The markets are the aggregation of a very large number of views and actions, and the efficient markets hypothesis argues that prices always reflect all available information. I struggle with this hypothesis but equally grapple with the idea that investment strategies can successfully be based on the notion that ‘the market is wrong’. It’s a probabilistic world, and experience, as a kind of human version of machine learning, helps one make bets on the most likely outcomes. One can’t invest in everything, so we think about a theme, take a view, make sure we understand risk tolerance and time horizon and make the bet. In the spirt of those comments, here are my end-of-year thoughts.
The period of runaway inflation is coming to an end. That does not mean the general price level won’t keep rising – it will, but hopefully at a diminishing pace. The data from October and November across several countries show inflation peaking. In the US, if you exclude everything you need for life (food, energy and shelter) prices fell in those two months. If the monthly increase in the consumer price index matches the historical average for each month until the end of 2023, then headline inflation in the US might even get back down to between 2% and 3%. The theme of disinflation is already driving markets and it will continue to do so, regardless of what the Phillips curve – the theory that inflation and unemployment have a stable but inverse relationship – says otherwise.
Shooting in the dark
Central banks have a unique role in financial markets. They directly control the cost of overnight borrowing which sets the tone for the entire interest rate structure. They can also ‘print’ and ‘destroy’ money. In setting interest rates and using their balance sheets they try to influence aggregate demand to meet inflation targets. The US Federal Reserve (Fed) raised its overnight interest rate to 4.5% on 14 December while the European Central Bank and Bank of England raised theirs to 2% and 3.5% respectively the following day. Central banks want to raise rates to levels that have a negative impact on borrowing (i.e. to restrictive territory). The problem is they don’t know precisely what that level is.
Question of belief
Fed Chair, Jerome Powell, is reiterating the message that the Fed will remain hawkish until inflation is meaningfully lower. That means another one or two hikes and no cuts in 2023. But the market doesn’t believe him. That is why the yield curve is inverted. In the famous ‘dot plot’ published after the latest Fed meeting, the estimate of the long-term equilibrium interest rates remained at 2.5%. The market simply does not believe the Fed can keep the overnight interest rate at double the long-term equilibrium rate for any prolonged period. With inflation falling and recession being a consensus forecast – is the market wrong?
I said we live in a probabilistic world. If inflation keeps falling and growth slows, the Fed will probably pivot next year. Of course, the data path could change again but increasingly the market is raising the odds that if Powell remains true to his word and rhetoric continues to be used as an additional tightening tool, then the risk of a policy mistake will grow.
Hindsight vs. foresight
We can look across to other economies. Global inflationary pressures are easing, and global demand is under pressure largely because real incomes have been hit by higher food and energy prices. Short-term interest rates remain below the current (backward-looking) rate of inflation but they may already be in positive territory if we incorporate a forward-looking view. The Bloomberg economic consensus forecast for US inflation in 2023 is 4.3% but by this time next year the year-on-year rate might be lower. The Fed Funds rate is at 4.25-4.5% today. I am with the bond market on this. Rates are already stepping into restrictive territory; inflation is receding and there are downside risks to growth.
Onto the knockouts
So I’ll stick with my bullish fixed income theme going into 2023. The best value is in the short end of the yield curve. The best risk-reward is in corporate debt at the short-end because yields are attractive relative to the duration and credit risk. Corporate risk premiums in fixed income are pretty much in the middle of their medium-term range. Some might argue they should be higher with recession ahead. However, it seems companies are in relatively good shape from a fundamental point of view. We can even say that high yield companies, overall, also look attractive from a bond perspective. Yields are high, prices are low and default risk is more limited than in previous cyclical downturns.
Can next year be any worse for equities?
A peak in inflation, a plateauing of interest rates and China re-opening are positive ticks for equity markets. The fourth quarter rally has been impressive, especially when the narrative is oncoming recession and earnings downgrades. Have we seen the low in equity markets? That’s a tough one. Valuations aren’t exactly cheap so if earnings were to fall going forward that would likely mean lower equity prices. Labour markets remain key. There has been a huge delta on real income this year. But unemployment remains low. If unemployment rises – which seems, incongruously, to be a target for central banks – then that delta on spending could be negative again. A year ago, markets were at higher valuations, rate hikes had not started. Inflation was only modestly moving higher and there was no Ukraine crisis. A lot of bad things have happened to send equity markets down. The lows of early this year could be tested but I suspect that a buy-on-dips mentality might start to prevail.
It’s been a bad three years for the economic model
I hope, when the obsession with the next inflation report and next rate hikes diminishes, the investment community can re-focus on sustainability. Responsible investing is about seeking to invest in assets that contribute to economic growth – and thereby produce a financial return – but also minimise the cost to the environment and society. There has been so much progress in recent years, but I would suggest that the journey has only just begun. So much economic activity still creates external costs. We can identify and price some, but not all of them. The last three years have not been good in terms of the trade-off between economic activity and the vulnerability of life to external shocks.
Even with energy
where there has been the most focus - there is a long way to go. Since 1965, for every 1% gain in global GDP, energy use has risen by 0.75%. Gains in efficiency are clear such that since 1990 that has fallen to 0.65%. It will continue to fall, but global energy demand is still rising and has done at a compound rate of 1.6% since 1990. As two-thirds of energy use still comes from fossil fuels, we are still increasing the use of oil, gas and coal combined, and still generating lots of carbon-dioxide emissions as a result. And this is even with our ability to price carbon which makes traditional energy generation less competitive than renewables. They still only account for around 15% of total energy output.
The investment theme of the energy transition will become ever more persuasive as new technology develops and becomes more scalable. Green hydrogen, for example, remains an embryonic technology but could emerge to fuel long-haul transportation and high-energy industrial processes. The investment opportunities are huge. Same with many other technologies such as carbon-capture (including nature-based solutions), and numerous technologies that contribute to energy efficiency. The more they are scaled up, the cheaper energy becomes, and the more sustainable economic growth will be. This will benefit all companies. In the short term, a fall in energy prices might be a significant boost to the broader industrial sectors in the stock market.
Carbon can be priced. Soil erosion not so easily
Biodiversity as an investment concept it just as important as the climate focus but harder to measure and price the complex ways economic activity adversely affects the land and the oceans. The global community needs a robust framework to assess biodiversity risks – and good work on that is progressing – but we also need more disclosure, more focussed policy, and the realisation that fundamental things about the way we live need to change. Food is a major area of focus because of the intensity of agriculture and the negative costs it can have on land use, water resources and emissions. Suggesting wholesale changes in diet are not practical without education and policy. Making consumption and investment choices are not possible without more disclosure about provenance and health impact.
Clean, renewable energy benefits society through lower cost and less environmental damage. Healthy food produced by sustainable methods benefits society through lower direct food costs (potentially) but lower costs in terms of social health. These are the utopias of changing our economic system to a more sustainable model. Investors can’t do it alone and it is hard work trying to get the right metrics, trying to comply with the regulatory requirements and trying to get the right level of disclosure from and engagement with the companies whose activities could have negative external costs. But we need to keep doing it.
The world has plenty of uncertainties ahead
One is the course of events in Ukraine and the related issues around Russia’s position in the international community. Neither a military nor a negotiated settlement appear likely. Another is China and how the re-opening proceeds. The New Year holidays at the end of January will be a major test. If China does fully re-open, there will be consequences for global growth and inflation. Chinese equities might be the star performer in such a scenario. Another issue, central to the policy question, is global labour markets. Everywhere I have been in 2022 I’ve heard stories about labour shortages. Official unemployment rates are low. Will this turn out to be the next source of inflation? At the same time there is an immigration problem as people flee politically and economically challenged regions. For Europe, particularly, politicians need to try to square the circle because otherwise we are not optimising the economic model. A sustainable economic system needs to use resources in the most efficient way.
And finally, football
I wish the best of luck to France and Argentina on Sunday. At least one Paris St-German superstar will end up with a World Cup winner’s medal. That alone will constitute a successful tournament for Qatar. Overall, it has been very entertaining with some surprises and some great football – as well as evidence that the global balance of footballing might has shifted. I can’t wait for the next one. Meanwhile, back to domestic and European football. Several Manchester United players had a good tournament, without injury thankfully. The global game has been enhanced by the Qatar World Cup, let’s hope the excitement and beauty transfers into an away game at Wolves!