Market Conversations: What’s in store for markets in 2023?

Brian Levitt:

Hi, I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips.  it's time to talk about our 2023 outlook. Joining us are Kristina Hooper, Chief Global Market Strategist, and Alessio de Longis, Global Head of Tactical Asset Allocation.

Brian Levitt:

Jodi, welcome to 2023.

Jodi Phillips:

Happy New Year.

Brian Levitt:

Happy New Year.

Jodi Phillips:

And good riddance to 2022. I wasn't really that upset to turn the calendar page this time around.

Brian Levitt:

Yeah, I think most investors probably felt that way. It's amazing how there's just something therapeutic about turning a calendar after a difficult year in the market.

Jodi Phillips:

No, you're right. There really is. But does it really mean anything? I mean, it may be a new year, but is anything really different, or has nothing changed?

Brian Levitt:

That actually sounds like a U2 lyric.

Jodi Phillips:

Does it?

Brian Levitt:

Do you remember that song about whether anything changes on New Year's Day?

Jodi Phillips:

Oh yeah, it sounds a little familiar.

Brian Levitt:

I mean, I think you could find strategists, pundits, the so-called experts on both sides of this debate. It's very bifurcated whether anything has changed as we move into this year, or if we're still grappling with all of the same challenges that we were dealing with last year.

Jodi Phillips:

Okay, so then what's your take?

Brian Levitt:

I actually think things have changed. The good news is, and we'll talk to Kristina and Alessio about this, the markets had already priced in a fairly bad outcome. We're seeing, from the Bureau of Labor Statistics, inflation coming down, perhaps the Fed's getting closer to the yen, seems like it's becoming a better backdrop for risk assets. So it's hard to say that nothing has changed. I think quite a bit has changed.

Jodi Phillips:

Well, that's good. There's still some negativity out there though. But I've heard you say before that market cycles seem to be born in pessimism. So I don't know, is that true here?

Brian Levitt:

Yeah, I think that's exactly right. Now, I'm not saying it's going to be easy. We obviously have some issues to deal with, but history suggests by the time inflation has peaked, or by the time whatever challenge you're facing is starting to get better, you tend to see a better environment for markets, albeit if it's not a straight line. But we're certainly getting to a better backdrop.

Jodi Phillips:

Well, good. I'm feeling hopeful. So let's continue this conversation with our guests. We're going to set the stage with Kristina, and then follow up with Alessio to talk about the asset allocation implication. That's hard to say, Brian. Asset allocation implication.

Brian Levitt:

That is hard to say.

Jodi Phillips:

Hopefully, Alessio will do a better job with it than I did.

Brian Levitt:

How now brown cow.

Jodi Phillips:

All right, got little rusty for the new year. In any case, welcome, Kristina.

Kristina Hooper:

Oh, thank you so much for having me. It's great to be here.

Jodi Phillips:

So let's start with a quick postmortem on 2022, if we could. I mean, it's hard to remember, but at that time, no one really expected that the Fed would tighten as much as they did over the course of last year. I mean, I don't think the FOMC really expected it themselves. So how would you characterize what we've been through?

Kristina Hooper:

Well, I know Brian referenced U2, but I'm thinking Talking Heads, how did we get here, right?

Brian Levitt:

Same as it ever was?

Jodi Phillips:

Great question, great question.

Kristina Hooper:

So you're absolutely right, Jodi. No one expected 2022 to play out the way it did, and that includes the Fed, right? If we think about December of 2021, when they released the “dot plot,” they anticipated that by the end of 2022, we'd be at 90 basis points for the fed funds rate. And then fast forward to the end of 2022, and we ended up in a far different, a far tighter place. So I like to think of 2022 as the year of monetary policy whiplash, which then turned into, in my opinion, when we looked at asset class returns, annus horribilus. But it doesn't sound as good as when Queen Elizabeth said it with that great British accent.

Brian Levitt:

Hey, 90 basis points to 450 basis points. What's the difference for markets?

Kristina Hooper:

Exactly.

Brian Levitt:

It's like a rounding error. So when you think about all of that tightening, and the economy's still generally resilient, how concerned are you about the lagged effects of that policy tightening?

Kristina Hooper:

Well, what we lived through in 2022 was a great experiment. We don't know exactly how much of an impact that fast and furious tightening has had. I mean, let's face it, the Fed did not allow for enough time to see the impact, and they certainly tightened in much larger chunks than normal. So you always, I think, in this kind of situation, would worry about the potential impact on the economy, how much damage was done. But from everything that I can see thus far, it looks like the US economy has been very resilient. In fact, many economies around the world have been quite resilient, despite what has been really, really intense tightening.

Brian Levitt:

The Hooper family is still going out to restaurants, still traveling occasionally? We're still spending some money like the rest of the Americans?

Kristina Hooper:

A little bit, but I have imposed new budget constraints.

Brian Levitt:

Yeah. Well, and that's part of it, right? I mean the idea was to make us all feel a little bit less wealthy. I think the Fed did a pretty good job of that. As we feel less wealthy and as we put some of those constraints on, do you start to think that that inflation story becomes a bit passé, or it's starting to move a little bit behind us?

Kristina Hooper:

I think so, and that's what we're seeing from the inflation data we're looking at, right? I mean, the most recent CPI print suggested that inflation is moderating nicely. Now, we're nowhere near the Fed's target. We're moving in the right direction. And I think we have to anticipate, as we look out on 2023, that this is going to be a period in which inflation is likely to continue to moderate. But we have to think of it in terms of the three buckets that Jay Powell laid out recently when he talked about inflation.

There is the goods bucket, there is the housing bucket, and then there is the services ex-housing bucket. And so clearly, goods inflation has come down very significantly, and housing, despite the most recent CPI print, appears poised to roll over. I mean, clearly, there's been a lot of pressure on the housing sector with mortgage rates going up so much, and I think that that will have an impact on housing inflation and help moderate it. But the real stubborn area is going to be services inflation, especially because so much of that is driven by wage growth. So we are going to see inflation moderate, in my opinion, this year. It's just unlikely that we get to the Fed's inflation target by the end of this year. I think that's going to take more time.

Brian Levitt:

Jodi, you heard Kristina say it, my wage growth is going to be just fine this year.

Jodi Phillips:

Oh yeah, we have that recorded. Absolutely. We all have witnesses. Obviously, looking past the US, we've seen the eurozone has also had to deal with pretty aggressive tightening. How is the eurozone economy holding up?

Kristina Hooper:

Well, it's actually held up relatively well, given all the headwinds that it has faced in the last year. Not only has there been significant tightening, but of course they have been subject to very high inflation, especially coming from energy. I mean, there's just been a lot of hits to the Eurozone economy, and yet what we saw in the most recent PMIs is that while they remain in contraction territory, they've actually improved. And so that suggests to me a Eurozone economy that is quite resilient.

Jodi Phillips:

What about China? I know the big headline there has been rolling back so many of those COVID measures that were in place for so long. How is that adding up in terms of your growth outlook for China?

Kristina Hooper:

Well, when we first sat down to talk about the outlook back in October, when we took a look at China and thought about what could be possible for 2023, we felt the economic outlook hinged on two factors: property and COVID. And what we saw was that Chinese policymakers have addressed the issues in the property sector. They released this 16-point plan this fall. That seems likely to have a material positive impact on the property sector.

So then the other issue is COVID. I mean, we've seen pretty significant COVID stringency in China, and rolling that back is going to create some headwinds initially, because of course there is a significant increase in COVID infections. But I think that opens the door for significant economic growth as the year progresses. I think we just have to anticipate some headwinds in the near term, but this could be a very positive year for China growth.

Brian Levitt:

Alessio, let's bring you into the conversation. Thank you so much for joining us.

Alessio de Longis:

Thank you, Jodi. Thank you, Brian. Always a pleasure being with you.

Brian Levitt:

So I know that you always like to think about it from the perspective of what phase we're in, or what regime we're in within the cycle. How would you categorize this current environment, where it seems like risk appetite may be picking up a bit from where we were, call it September, or maybe even a little bit in December?

Alessio de Longis:

Yeah, the market has certainly, since late November, early December, has certainly started picking up a much, much stronger tone. The way I would like to characterize it is that we have basically been waiting for that recession for six to nine months now, the most well-telegraphed recession that, of course, didn't happen. So since early December, what is happening is that inflation, and therefore speculation on the end of the tightening cycle, inflation is rolling over more quickly than growth is rolling over. So the market is feeling optimistic, because it's finding that sweet spot now where inflation may be coming down, monetary policy tightening is coming to an end, while growth, as of today, is still holding up.

Brian Levitt:

So that sounds like a soft landing. Is it a soft landing? And for investors, does it have to be a soft landing, or have we already priced in a mild recession?

Alessio de Longis:

I think right now a soft landing is really the best way to characterize it. Basically, we have knowledge that growth has been close to zero, but now we can see light at the end of the tunnel and expect it to actually rebound, rather than going into negative. So we will characterize that market reaction more consistent with the market pricing and recovery regime, right? Growth still being low, but actually improving.

How long will that last? Well, this goes back to the eternal debate about the long and variable lags of monetary policy. I agree with Kristina. At some point, it will be more obvious what the damage has been or will be from past monetary policy tightening, but it's not here, and it doesn't have to be that severe. The unemployment rate is still globally near all-time lows. So without a doubt, this is not the beginning of a new economic cycle, precisely because the unemployment rate is at all-time lows, but we are dealing with a soft lending, similar to...

Brian, I like to draw analogies. Obviously, the circumstances were very different, but remember how many fake recessions we had, such as in 2011, in 2015? To me, the relationship between the economic situation and the market reaction is analogous to those. Those were very difficult years from a trading perspective, and there were large negative returns, but the economy ended up holding up and eventually the market recovered. So that's how I think the market is pricing in, basically, reduced risks of a recession in timing, in duration of that recession, and potentially the magnitude of that recession.

Brian Levitt:

That's interesting you bring up '15 and '18, I mean, '15 was, what, one rate hike, a Chinese currency devaluation? '18 was a US-China trade war. In hindsight, do those pale in comparison to what we've just seen, a 450 basis point rate hike in nine months? So I'm trying to get what you're saying. You're saying that it feels like a soft landing. We may still need to bump on the bottom a little bit. Is that what you're suggesting? But we're not there yet?

Alessio de Longis:

What I'm suggesting is that the market is... It's ill-advised to position with bearish traits, to position for a recession for too long. As we all know, positioning for a recession, be it in credit, in fixed income, in equities, it's an expensive proposition, right? Waiting for that recession to happen is difficult. So unless you have the evidence staring at you that that recession is rising in probability, no news is good news. And in front of no news, or improving news such as falling inflation and a toning down of hawkish rhetoric by central banks, those are catalysts for a better market environment that should not be ignored.

I guess my point is to say, yeah, the market is recovering, but wait because a recession will eventually come? No. Actually, thank you for asking that question. What I want to be clear on is that you need to acknowledge what the market is doing, and when the economy begins to deteriorate, when you begin to see those cracks, be it the unemployment rate, be it credit spreads, we have another chance at being more cautious and defensive. But right now, we are seeing some pretty convincing signs across all capital markets that we should take seriously a potential rebound in economic activity, especially, as Kristina mentioned, in the weakest zip code, which is Europe.

Jodi Phillips:

So Alessio, help me figure out what this means for portfolios and investors and asset allocation. You talked about seeing some convincing signs. For those who are tactically minded, they're trying to figure out what they should be doing at this moment as we're looking for signs and looking for evidence, what types of assets are you favoring?

Alessio de Longis:

So for the last couple of months, where we've begun to see this improving risk sentiment and falling inflation statistics, we have gone back to overweight equities. In other words, we believe that it's appropriate to run above-average risk again after being very defensive in the second half of 2022, above-average risk being expressed through both equities, but primarily, risky credit. Credit spreads are still wide above their long-term average, have started to come in, but they're still wide. You are still getting compensated.

As investors, we're now having the opportunity for 5% to 9% yields that we haven't seen in the last 15 years, so it's a golden opportunity to rebuild income in the portfolio to harvest some credit risk. In this particular market context, risky credit such as high-yield emerging market debt or bank loans offer equity-like returns, but with lower volatility. So that's important. In the equity space, I think it's appropriate to run some slight equity overweight, but primarily within that equity composition, favor value over quality, favor small and mid caps over large caps. In other words, favor the more cyclical sectors and more cyclical styles of the market.

Brian Levitt:

Let's go back to fixed income. You talk about, when you say 5 to 9%, 9% is pushing out in credit risk, so call it, what, a high-yield bond index around 9%. Is that enough in your mind to compensate for any type of default cycle that we may have?

Alessio de Longis:

That's a good question. So harvesting that yield in a very diversified way, it's always the best strategy. I think defaults, if they occur, are... Given how de-levered these sectors have been, how... We have gone already through a large cleansing of the debt situation, both on the consumer side and on the corporate side. Default rates, which will inevitably rise in the worst-case scenario, should not be large, systemic to lead to underperformance on a two, three year rolling basis on risky credit, in my opinion, and also, especially for the risky credit cores that also have duration. So in that sense, emerging markets debt and high yield offer more duration than bank loans, and that duration always offers a little bit more of a ballast than the purest credit exposure. So yes, I think on a two, three-year rolling basis, these level of yields are quite attractive, in my mind.

Brian Levitt:

Now, Kristina's always asking me what's the top question I'm getting from clients, so I will pose the top question I'm getting from clients to you, Alessio. When you're thinking about-

Alessio de Longis:

Bring it on.

Brian Levitt:

When you're thinking about generating income and you want to do so, perhaps call it in the Treasury market, are you taking advantage of two-year yields at four and a quarter (percent), or are you moving out in the yield curve where you're only getting on a 10-year, say 350 (basis points), but does longer duration make more sense if the economy slows in here?

Alessio de Longis:

That's a great question, and one that is really, really topical at the moment. For the first time in three years, we are moving away from flattening yield curve exposures. In other words, the yield curve is now inverted by a full hundred basis points, when you look from T-bills to 10-year Treasuries. That, for our generation, is as flat as it has ever been. The only times the yield curve has been more inverted than that was in the 1970s, in the 1980s where it got to negative 150. Obviously, the inflation situation today is comparable to that one, but it gives you an idea of the risk-reward.

So to answer your question, we are now starting to move out of the long end in terms of where do we choose to have our duration exposure. We're starting to come back up towards the two-years and five-years, where you now can harvest 4%, 4.5% yields. It takes basically a doubling of those yields for you to lose money on those bonds, right? So especially on the two-year, this is now becoming really, really attractive.

The two-year, obviously, because we're going, we believe that the Fed will eventually pause, and the market will begin to price in some easing. Whether the Fed delivers that soon or not, that's a different question, but the market always starts pricing in the beginning of the next cycle. Being in two-year bonds, in three-year bonds might give us also an extra juice in terms of declining yields, rather than being in cash at three months. So yes, I think the front end of the curve is now starting to look quite attractive.

Jodi Phillips:

All right. Well, Brian covered what the top question is from clients that we're hearing, so I'll ask my personal favorite question, and I want to ask you and Kristina as well. What are people not asking you? What are you not hearing about that you think people should maybe be paying more attention to at the moment? Alessio, do you want to go ahead and start? And I'd like to hear from Kristina as well.

Alessio de Longis:

Well, Kristina, I'm very curious about your opinion, but I am quite amazed by the lack of interest and inquiries on non-US assets, on emerging markets, on China, on Europe, despite the fact that a cycle has clearly ended, the growth versus value cycle. The unconventional monetary policy cycle has clearly ended. These were major factors that contributed to the US dominance, the US excellence. All of these catalysts are, one by one, unwinding, and yet there is so much skepticism around investing money in international markets. The euro went from 95 cents to 1.10, almost, and nobody's asking. So what I think this is, we always focus on tactical, tactical, tactical, but I think these tactical rotations are probably signaling the beginning of a new long-term cycle of rotation and diversification out of the home buyers in US assets into foreign assets.

Brian Levitt:

Before we hear Kristina's opinion, Alessio, I just want... Obviously, Bitcoin went from 16,000 to 18,000, so that's why nobody's paying attention in the euro, but talk about Europe, because it's just been so negative, right? You have the conflict that's existing in Eastern Europe, you have concerns that Germany might not even be able to keep the plants operating because they don't have access to the commodities that run it. How do you get investors to think optimistically about Europe in that type of a backdrop?

Alessio de Longis:

Generally speaking, what you just outlined reminds me of a lesson that I learned over the years, which is we always need to find comfort in a narrative, and a narrative always obviously makes sense. The problem with narrative-driven investing is that you also need to mark the market, and when the pricing changes, the narrative is still in place, but the pricing is changing. What does that mean today?

Europe remains the most geopolitically vulnerable and economically vulnerable region through the current situation, but we have been pricing that for 12 months. In other words, as Kristina mentioned, the PMIs are in recessionary territory, but they're starting to bounce back up. Consumer confidence has been at all-time depressed levels, well past even 2008 levels, and they're bouncing back up. The winter freeze that we were fearing, because of what the implications will be for natural gas prices and energy provision, the winter is turning to be much milder than expected.

So there is so many catalysts, one by one, that again, the narrative has not changed, but the risk and the pricing around those catalysts is now improving meaningfully, which is why European equities are reacting so positive. I think that's really what the key question here is. And one more point: let's not forget that Europe is the most cyclical region in the globe, and with China reopening trade in the horizon, that remains one of the regions that is likely to benefit the most from a global trade perspective.

Jodi Phillips:

All right. So Kristina, question comes to you then. What topics are flying under the radar that you think people should be paying more attention to right now?

Kristina Hooper:

Well, I absolutely agree with Alessio that one topic that we don't hear anything about, we don't see really very much interest at all in, is investing internationally. Europe, emerging markets, it's just not a focus for investors right now, and Europe, it's all about beating expectations, and that's what we're seeing right now. I couldn't agree more with Alessio. The other topic that I think I'm not hearing enough about is what Alessio called, and I love this term, the golden opportunity to rebuild income, and it really is. I think some have not realized just how robust yields are on investment-grade corporates, on a number of different areas within fixed income, and I just think there's not enough interest and focus there right now.

Jodi Phillips:

All right. Brian, do you think we've covered it? Anything else you want to ask?

Brian Levitt:

I'm just still happy that we turned that calendar page, Jodi. I mean, isn't this such a better vibe than what we were talking about, call it mid-summer?

Jodi Phillips:

It does. It feels a lot better, so let's just watch how it all turns out and shapes up. We've got a long way to go, but feeling a lot better after this conversation, that's for sure.

Brian Levitt:

We're feeling a lot better, and we know that Alessio and Kristina are going to be with us along the way to keep providing their insights as events unfold throughout the year.

Jodi Phillips:

Thank you so much for joining us.

Brian Levitt:

Yeah, we thank you so much.

Alessio de Longis:

Thank you for having us.

Jodi Phillips:

Happy New Year.

Kristina Hooper:

Happy New Year.

 

 

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In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

 

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

 

Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

 

Issuers of sovereign debt or the governmental authorities that control repayment may be unable or unwilling to repay principal or interest when due, and the Fund may have limited recourse in the event of default. Without debt holder approval, some governmental debtors may be able to reschedule or restructure their debt payments or declare moratoria on payments.

 

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

 

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

 

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

 

The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

The Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.

 

According to Bloomberg, the federal funds rate was 90 basis points as of December 31, 2021, and 450 basis points as of December 31, 2022.

 

The federal funds rate is the rate at which banks lend balances to each other overnight.

 

A basis point is one hundredth of a percentage point.

 

Tightening is a monetary policy used by central banks to normalize balance sheets.

 

The Consumer Price Index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics.

 

Purchasing Managers’ Indexes (PMI) are based on monthly surveys of companies worldwide, and gauge business conditions within the manufacturing and services sectors.

 

Information on US economic growth from the US Bureau of Economic Analysis.

 

Information on the US unemployment rate from the US Bureau of Labor Statistics as of December 31, 2022.

 

Information on credit spreads from Bloomberg, as of December 31, 2022. Based on the Bloomberg US Corporate Bond Index Option Adjusted Spread. 

 

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market.

 

The option-adjusted spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to account for an embedded option, such as calling back or redeeming the issue early.

 

The reference to yield opportunities ranging from 5% to 9% are based on the yields-to-worst of the Bloomberg US Corporate Bond Index and the Bloomberg US High Yield Corporate Bond Index as of December 31, 2022. 

 

The Bloomberg US High Yield Corporate Bond Index tracks  the performance of below-investment-grade, US-dollar-denominated  corporate bonds publicly issued in the US domestic market. 

 

Yield to worst is the lowest potential yield an investor can receive on a bond without the issuer actually defaulting.

 

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.

 

Information on 2-year, 5-year and 10-year Treasury yields from Bloomberg as of December 31, 2022.

 

Information on current and historical inverted yield curves is from Bloomberg, as of December 31, 2022.  Based on the spread between the 3-month and 10-year US Treasury rates.

 

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.

An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality.

 

Information on the level of the euro from Bloomberg. Based on the move in the exchange rate between the euro and the US dollar from October 2022 to January 12, 2023.

 

Information on the price of Bitcoin from Bloomberg. Based on the price change of one Bitcoin from the beginning of 2023 to January 12, 2023.