Global Outlook 2023!
How To Brace Your Portfolio For The Upcoming Recession!
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USA!
The US economy exhibited remarkable strength during 2022 as the excess savings accumulated during covid and higher wages led to strong consumer demand.
However, as we head into 2023, consumer strength has waned. Nevertheless, the consumption measured by real retail sales is still positive, albeit on the margin.
On the contrary, several leading indicators are flashing a looming recession in the US.
The Conference Board Leading Economic Index (LEI) consist of ten components, including key indicators such as ISM, Building permits, Stock Prices, Credit Index etc.
As we can observe that the index has entered negative territory since August. Nonetheless, the 2008 recession transpired a year after the LEI flashed red. In fact, the index recovered before tumbling to extreme lows.
Though the 2008 scenario is not identical to today’s economic health as the US Households (HH) and corporates have significantly deleveraged in the last decade. However, one can’t ignore the fact that in 2023, we will witness the growth momentum slowing down considerably.
One of the precursors for NBER to declare a recession is a significant rise in the unemployment rate. I have been very vocal about how resilient the labour markets have been due to structural reasons.
Therefore, there is a real probability that we may get a soft landing initially, aka growth stalls materially, but the unemployment rate stays below 6%. Having said that, the material risk is that a soft landing may reignite inflation back above 5%, and thus a hard landing may be required to bring back inflation to the 2% target, which will result in mayhem in the financial markets.
So, where do we stand in the portfolio allocation with this macro backdrop?
Well, the US equities are a big “NO” for “the”next year as the recession will most probably lead to a fall in earnings. The historical data also indicates that the markets bottom out when the macro data worsens, and the yield curve steepens from the inversion. (as the Fed pivots)
Regardless, some of the sectors remain in the bull market.
As the era of cheap money ends, we may see a seismic shift in investor’s positioning as the “great” rotation takes place from growth to value stocks.
Value stocks, especially those with pricing power, may continue to outperform the broader indices and the tech stocks as inflation may remain sticky in case of a soft landing scenario (high nominal growth will aid the topline). However, a hard landing will lead to negative returns for even the value basket.
On the other hand, the bond markets look really interesting. It is anticipated that the Fed might keep rates longer as it hits the terminal rate in February (5%). The front end of the curve appears attractive as the curve will most likely steepen starting from Q2 2023. Very Long-term investors can allocate the money to the 10-year (above 3.5%), as the real yields remain positive.
For short-sellers: A recession always leads to widening HY credit spreads. Therefore, people can go short on the HY index as the spreads will likely widen considerably next year before the Fed cuts rates.
The DXY has significantly corrected from the high of 115 as the other CBs in the Developed markets catch up with the Fed. As the tightening cycle across the CBs come to an end by Q2 23, the DXY might remain rangebound. 100–110 levels on DXY look plausible unless some exogenous shocks drive the greenback on either side of the range.
Emerging Markets!
Most emerging markets were butchered in 2022 as the dollar wrecking ball was in full force. In fact, as I covered in my newsletter: “Lost Decade”, EMs have undergone a lost decade as investors failed to realise realize any returns on either EM bonds or EM equities (in USD). Yet, the EM equities are now at one of the most attractive valuations ever.
Some markets, like Brazil, Indonesia and Mexico, are screaming long-term buy as the valuations are conducive, and the growth-inflation dynamics are well aligned.
India, though quite expensive compared to historical valuation, can be a long-term buy as the demographic dividends will reap rich dividends in the upcoming decade. Furthermore, the cyclical sectors have started to perform after a long time. However, I remain cautious and neutral on Indian equities as a global recession might play spoilsport in the short-medium term.
Thus I am playing India in my model portfolio via financials which are witnessing high double-digit credit growth.
Some of the market participants are also increasingly becoming optimistic about China. Furthermore, reopening trade aided by the colossal monetary and fiscal stimulus might lead to accelerated GDP growth in the next two years.
As the cyclical activity picks pace in the next 12 months due to unprecedented stimulus, the credit impulse will most likely inch upwards, as observable in the previous cycles (see chart).
As a result, I remain overweight on Chinese equities.
Euro Area (EA)
EA is on the brink of the worst-ever recession as double-digit inflation led by the energy crisis creates havoc on consumers and industries.
Europe’s outlook for next year looks extremely gloomy as the ECB continues to hike rates into a recession. While the nominal GDP will be inflated due to high inflation, the real GDP is projected to fall by 1%.
Source: Barclays
The various high-frequency indicators indicate that consumers and businesses are feeling the heat of abnormally high energy prices. As a result, it is expected that real disposable incomes will continue to plunge next year, leading to reduced consumption.
Furthermore, the business surveys point out that businesses are already witnessing worsening prospects. We might see unemployment pick up in the EA as businesses resort to cost-cutting measures to avoid closures and losses.
The EA unemployment rate is at a historic low of 6.5%. The “exceptionally” resilient labor markets and unionization continues to put upward pressure on wages amid record inflation. Until the unemployment rate inches up to 8%+, as visible in the past recessions, the wage-price spiral may persist, and Europe will reel under stagflation.
The EURUSD broke parity this year and has now rebounded as the rate differential (FFR and the ECB deposit rates) declined after the ECB aggressively followed its counterpart in the US. However, EUR is expected to remain under pressure in 2023.
If the weather lords don’t grace Europe, and the energy crisis worsens in 2023 (“The Giant Squeeze”), the EUR might again breach parity. Overall, I expect the EUR to trade in a broad range of 0.90–1.10.
Canary In The Coal Mine!
The US housing markets will not collapse like the 2008 GFC due to the low leverage in the housing market compared to the 2008 crash. Nonetheless, the canary in the coal mine is the housing sector in some G20 countries, where there is a high probability of enormous housing crises which can paralyze their economies.
The last two decades saw gargantuan price rises in the housing sector across the various G20 economies as excessive leverage, higher demand from immigrants, and wild speculation led to a massive influx of capital in the largest asset class in the world.
Canada, Australia and New Zealand are the countries where the housing market saw the build-up of unprecedented leverage, and the prices skyrocketed to unsustainable levels in the last decade.
As the interest rates rise in these countries, there is a grave risk of a bubble burst which may be catastrophic for the banking sector, consumer sentiment and the economy as a whole, leading to a severe recession next year.
You will be astonished to know that the Reserve Bank of New Zealand has been on a hiking spree since October 2021 but has failed to tame high inflation. As the rates in the most vulnerable countries are expected to remain higher for longer to control inflation, the risk of a massive housing crisis remains elevated.
Canadian Dollar (CAD) and Australian Dollar (AUD) will most likely underperform next year massively as the domestic economies are expected to remain relatively weak due to the slowdown in the housing sector.
Commodities and Gold!
Anticipating a recession, commodities ended the year on a flatter note YTD. However, we saw a late rally in December China’s reopening hopes triggered positive sentiment across the commodities basket.
Natural gas prices are expected to remain elevated in 2023 as the market remains tight due to buoyant demand from Europe, China and Japan. On the other hand, oil prices might remain highly volatile as OPEC+ is comfortable with a range of $80–90 for Brent Crude.
Base metals like Aluminium and Zinc might also remain rangebound as the Chinese demand might counterbalance the falling demand from the West.
The two metals that one should closely watch are Copper and Iron ore. While the Copper market is expected to be in a huge deficit next year, as per Glencore, the Iron ore prices can rally up to $150 /t China’s reopening gathers pace and construction activity reaches the pre-pandemic levels.
Gold prices are expected to remain stable. However, we might see some price action in Q4 2023, as the Fed pivot might make headlines by the end of the year leading to a rally in gold prices in USD terms.
Disclaimer
The author is not a licensed investment professional. Nothing produced under Marquee Finance by Sagar should be construed as investment advice. Do your own research and contact your financial advisor before making investment decisions.
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