2022 Overview and 2023 Market Outlook
In 2022, 3 main events affected the stock market: the war in Ukraine, the end of monetary easing and the fight against inflation. Not surprisingly, the performance of all asset classes is negative this year, despite a few rebounds.
At the beginning of this year, Russia’s intervention in Ukraine at the end of February shocked the world. The human impact rippled through the markets, with stocks falling and bond yields rising. The invasion heightened existing concerns about inflationary pressures, particularly in food and energy, with the consumer price index hitting 7.9% in the US in February and 7.5% in Europe in March, levels not seen in decades.
The second quarter was marked by further declines in stocks and bonds worldwide as markets braced for further interest rate hikes and the risk of a recession. Geopolitical tensions continued to worry investors, disrupting energy markets and driving up inflation. The latter raised the risk of recession in the minds of investors, prompting new policy responses from central banks. The declines affected all sectors except consumer goods, which held up well in the quarter. Within equity styles, yield stocks outperformed growth stocks, but both saw sharp declines.
Stocks and bonds fell after rallying in July after a better-than-expected earnings season and posted negative returns in the third quarter.
Any hope of a cut in short-term interest rates was dismissed by central banks, reaffirming their commitment to fighting inflation. Aggressive tightening led to further declines and more market volatility. As the economy began to slow, commodities underperformed, with energy, industrials and precious metals falling.
Easing inflationary pressures toward the end of the year spurred gains in stocks and bonds early in the final quarter of the year. However, the Fed’s hawkish guidance, disappointing economic data and negative earnings confirmed the slowing economy and led to a correction in December. For the year, the MSCI world has fallen sharply -13.11%. All geographies ended in negative territory, except for Latin America, which grew by +16%. However, note the eurozone’s performance over the US with the Eurostoxx down -9.45% versus -13.1% for the S&P 500 and -28% for the Nasdaq. And the bond markets fell by more than 12%.
There was no Diversification in 2022 because bonds and stocks were highly correlated and fell together. For us, the key question that will characterize 2023 is how soon can inflation return to the official target of 2%, and to what levels should central banks raise key interest rates to achieve this? Could a recession be a conceivable scenario, and if so, with what violence and for how long? Therefore, one of the main problems will be to be able to assess the impact of monetary policy tightening on the economy in a more or less short term.
Therefore, market volatility should continue at the beginning of the year. The outlook for the global economy for the coming year is mixed. As the year progresses, inflation is expected to peak in 2023, providing relief to the bond market, which has avoided a significant increase in energy prices. In either case, rates will not peak before inflation falls below key rates. However, the decline will have to wait until inflation drops significantly. A recession in Europe seems inevitable, but the US economy can avoid it. This possible recession could be very different from previous ones. Indeed, strong labor markets and demographic deficits may allow consumers to emerge from this uncertain period with stable incomes. Even if the rhetoric remains aggressive for now, central banks may become increasingly dovish next year to combat a possible recession or collapse in growth. The labor market holds the keys.
A deep inversion of the yield curve indicates that the global economy is weakening. Other major central banks, notably the ECB, will lag behind the Fed in terms of monetary easing. Although the peak of inflation is certainly behind us, the trajectory of interest rates still remains on the upward trend of the beginning of the year. Nevertheless, bond assets should regain their diversification power in 2023. The 4% nominal yield on US 10-year Treasuries is now high enough to attract income-seeking investors, offering risk-free capital appreciation in an environment of positive real yields. United States. On the credit side, this asset class can also earn interest again with sharply recovering yields. Corporate bonds are benefiting from yield levels not seen in more than 10 years. The outlook for this asset class will depend on the evolution of economic conditions and the rise in default rates, which should rise from historically low levels in this uncertain context. However, the expected growth should be less strong than in previous phases of the slowdown. Finally, common carry offers a cushion of protection against an upward correction in rates for this asset class.
Equity markets, in turn, will face the evolution of corporate earnings, which in our view will be decisive in the final performance, following a sharp rise in interest rates. One of the biggest themes of the year where valuations could be constrained will be the trajectory of earnings per share, and therefore margins. Synchronization of global growth between the United States, Europe and China is very clearly contributing to increased exposure to international markets outside the United States this year. Several factors contribute to this position. The first is that the US stock market is much more expensive than others, the dollar will continue to weaken in 2023, increasing the attractiveness of international markets. The 31% discount of European stocks compared to American stocks has never been higher than it is now.
The assumption of a recession in Europe has already been partially priced in by the European market at these valuation levels. In addition, the reopening of China’s economy and easing of its covid policies will be favorable for commodity prices and related markets. Excluding the US and emerging markets, particularly through Chinese stocks and emerging Asian stocks, international stocks have the potential to offer above-average returns, even if they could be shaken by a resurgence of Sino-American tensions, in our view. Overall, we are cautiously slightly overweight bonds in Q1 2023. If inflation continues to fall, central banks may accelerate the implementation of the pivot, which will raise growth expectations and thus yields. After that, it will be necessary to increase the exposure to stocks. In the end, it will be necessary to demonstrate agility and flexibility once again throughout the year.