News & Insight Market Insights

18 January 2023 | Simon King

Thoughts on 2023: Reasons to be Cheerful

As most of our regular readers will know, our views on the global economy and macro-outlook over the past two years have been somewhat gloomier than most. We take no particular satisfaction from the fact that we have been broadly correct and that both economic and market performance have been extremely disappointing, both in absolute terms and relative to expectations.

As we now turn our attentions to the outlook for 2023 and beyond, it would be easy to continue with our bearish outlook. We fully expect global economies to continue to suffer the headwinds of low growth, high inflation, COVID-19, protectionism and geopolitical unrest. Interest rates will continue to rise throughout the first part of 2023 and in our view will subside less quickly than the market currently anticipates. We continue to emphasise that it is where interest rates, inflation rates and growth rates end up that is important, not how we get there and where things peak.

Put bluntly we need sight of the new normal. It will not look like the past 15 years, which will mean a whole generation will have to adjust their expectations and yardsticks. However we are great believers in the adaptability and ingenuity of the global population, and we are beginning to identify a number of more positive signs and indicators. The 1979 classic by Ian Dury and the Blockheads which forms the title of this piece, was originally a shopping list of things to be cheerful about. The following is our list of reasons to be more optimistic and where we can identify the possibility of surprise in the year to come.

Before we reveal our list, it is worth laying out how we see things mapping out over the next 12 months. Initially, it may not be possible to discern any major change from the patterns we witnessed in 2022, due to the numerous headwinds we previously listed. In addition to these the equity market will have to navigate a very difficult Q1 reporting season, which will lead to earnings forecast downgrades and make the market look more expensive. With macroeconomic news flow likely to be very mixed and the lack of clarity on what investors currently regard as bad news, it will be difficult for any asset class to make significant progress. The market needs to decide what it is cheering for; high growth, low inflation or low interest rates at. At present it is impossible to achieve all three simultaneously.

We are however, starting to see geographic divergence in the performance of individual economies. We have argued for some time that although inflation has been the key topic in all markets, in reality the sources of inflation are very different in different geographies. The US has a tight labour market coupled with supply chain issues and a strong currency. Europe suffers from structural growth issues and an over reliance on Russian resources. Japan imports all of its inflation and is desperate to create some of its own.

The UK suffers from all of these problems and is also dealing with the ramifications of Brexit. This will mean that moving forward, inflation will subside at varying rates around the globe. This will in turn have a major impact on specific growth and interest rates and lead to divergence in performance. The key question is when will the market start to look through the current malaise and begin to predict more buoyant conditions? We believe this will occur in the middle of this year for the following reasons:

News Flow Ameliorating

Overall we believe we are nearer the end than the beginning of the current period of economic turmoil. This is important since rightly or wrongly, markets like to look through what is happening right now rather than what they think will happen in the future. Economies always adjust to what is thrown at them and although we believe that bad things always happen, the recent combination of COVID-19 and Ukraine will hopefully not repeat.

Inflation Coming Down

Inflation will come down. It is simply a mathematical rate of change. It will continue to be very stubborn, and people will be permanently poorer, but it will fade. It is remarkable how consumer confidence increases once prices are more stable and once inflation settles it will help consumers and businesses start to see the new normal.

Energy Prices Falling

A major component of the reduction in inflation will be that energy prices will fall. A simple combination of marginally increased production, reduced demand due to recession and a warm winter, will make this inevitable. This fall will not solve the long-term issues on energy supply and security, but it will have a major impact on short-term economic performance.

Labour Markets Improving

People will return to the workforce, thereby reducing labour shortages. This will be due to economic factors ie they cannot afford not to work and hopefully improvements in overall health levels will increase workforce availability, as the impact of COVID-19 dissipates. Non-participation in the workforce is a very poorly researched and understood dynamic which has had a much bigger negative impact than figures suggest.

Supply Chains Are Normalising

Global supply chains are correcting as companies reorganise manufacturing techniques and locations, which will both reduce input costs, and increase volumes in industries that have really suffered in the past three years. Again recession will make this process easier.

Valuations Changing

Valuations in many asset classes now discount the current period of malaise and more. There are still pockets of over-valuation, but some asset classes are plain cheap.

 

These factors will combine to produce a more positive backdrop throughout 2023 and should leave us exiting the year on a more positive tone than in 2022. We are not the only commentators suggesting this but in addition, we have also identified a number of potential surprises for the market:

Inflation Persists

We have been very vocal on our thoughts on inflation (see our various previous commentaries, podcasts, and presentations). That we have been largely correct in dismissing the fatuous argument over transient vs persistent inflation, and the central banks inability to put the inflation genie back in the bottle, is of little solace. We base our views on the real world, observing price increases that will impact inflation in the future not just now. In the UK the outlook is dim, with major public sector wage increases inevitable later in the year and power subsidies having to end. In other economies, with no Brexit or labour supply issues, inflation will moderate, but slowly. Other geographies will see inflation abate more quickly but we have a nagging doubt that this will still be to higher levels than people are hoping for.

Interest Rates Stay High

If we are right on inflation staying higher then unfortunately interest rates will also have to remain at higher levels than hoped. The area that the market generally still fails to focus on is growth, which is somewhat surprising. High levels of GDP growth can accommodate higher inflation and interest rates and, in our view, should be the starting point not the afterthought.

GDP Growth Returns

Most forecasters remain busy slashing global growth forecast for 2023. Much of this is because their forecasts were far too high in the first place, but some reflects the short-term pain of the rapid recent rises in interest rates around the world. Again we see the possibility of upside surprise based mainly on a better starting point ie the US and China will not be as bad as anticipated and for different reasons will be able to accelerate growth into 2024.

US Avoids Recession

We have commented previously on the US economy’s remarkable levels of inbuilt optimism, entrepreneurship and ability to adapt. It may be that these will once again be enough to stave off a real recession, particularly if the dollar does not weaken from here. This would mean higher interest rates for longer. However the market will probably adjust to this and start to focus on growth prospects.

China Rebounds More Quickly

China has performed a remarkable pivot on its COVID-19 strategy, moving from zero tolerance to attempting herd immunity in less than a month. Since no nation appears to have executed a successful COVID-19 strategy, we have no idea what the short- and long-term implications of this policy will be. What we do know is that this will change economic performance in China and with its trading partners. We are great believers in China’s unique ability to manage such changes effectively and as such China could see much higher levels of growth than the market is anticipating.

Ukraine War Abates

We usually do not comment or pass judgement on political or geopolitical matters, as everyone has their own views, hues, and opinions, and we have little to add. However, wars are major economic events in their own right and this one has had a massive impact on the global economy. Our point is that the market discounts a long and drawn-out conflict and is not priced for any sort of partial or complete solution. Trade patterns have changed and will not return to their previous shape, but greater certainty should not be undervalued.

Dollar Strengthens / Sterling Weakens

If the US recession is either shallower than expected, or even non-existent, then the growth outlook for the US will be considerably better than most other areas and as we said interest rates will stay high. In this scenario we see the dollar strengthening from its current level. The state of the UK public finances and elevated inflation causes us to see little scope for sterling to strengthen.

Japan Outperforms

As perennial optimists of Japan, we could not fault readers for crying “not again” on predicting its economy and market, will finally outperform. Nothing the Japanese government does seems to placate negative sentiment and its stock market and currency remain weak. All we know is that there are a very large number of very good companies, with incredibly strong balance sheets that do not rely purely on the domestic Japanese market for growth. They trade on very low ratings. At some point this value will be realised.

UK House Prices Don’t Collapse

Underlying there is a severe shortage of housing stock in the UK and put bluntly people have to live somewhere. Therefore we see strong rental prices and a more normalised mortgage market ie 5-year mortgages at 4% to 5% as huge supports to UK house prices. We are firm supporters of the UK housebuilding sector. We see it in a very different position compared to 2008. It is in much better shape to weather the storm. The next 12 months will be very difficult with very low volumes, but virtually all the sector have the balance sheets to survive this

Bonds Underperform Equities

One of the major problems for investors in 2022 was the high level of correlation between asset classes. Put simply nearly everything went down. Since everything went up in the years preceding 2022, one could argue this should not have been a surprise. We reiterate our view that interest rates will stay higher for longer and as such, do not predict a major rally in bond prices. If both China and the US economies are stronger than predicted and the rest of the world stops short of severe recession, then global growth levels could surprise on the upside. This will provide a good backdrop for equities, even if inflation remains elevated.

At Vermeer Partners we are not overly concerned with consensus views and forecasts. We also do not like to take contrarian positions purely for the sake of it. However, the only factor tempering our more positive outlook, is the fact there appears to be an emerging consensus that markets will improve in 2023. This will mean the herd will be looking for any indication that things have turned and will lunge at the market, possibly creating a “suckers rally”. There are still very excessive amounts of liquidity in the system, due to Quantitative Easing (“QE”) and as such the rally could be quite large. The problem is the one thing we can be certain of is that news flow is going to be very mixed for some time to come and a run of bad news may plunge the market into new depths of despair. In our view this would represent a good buying opportunity.

In conclusion 2023 is likely to be a transitional year. It will not witness the unbridled pessimism of 2022, nor will it revert to the unbounded optimism of the previous decade.  Markets will have to adjust to changing inflation, further movements in interest rates and possibly increased central bank tightening. However markets are good at adjusting, particularly once they sense a clearer path. We remain cautious on the outlook for the first half of the year since economic data will deteriorate and earnings forecasts will come down. We would urge patience and to try to avoid the usual noise and truisms created by the market commentators who argue mean reversion, comparisons to previous cycles and rotation. The key will be to continue to look forward and not in the rear-view mirror and as always identify investments in high quality companies and income streams that have the ability to prosper in all market conditions. There is light at the end of the tunnel.

 

 

 

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