As is often the case, financial market performance this year has wrong footed the investor consensus on a number of fronts.
In this note, we share our thoughts on some of the key financial and economic surprises so far this year, with an eye to the year ahead.
Global Equities Bounce back Strongly in 2023
Global equity performance has so far positively surprised what was a cautious consensus view at the start of this year. A strong performance from global equities has been led by a resurgence in performance of the US equity market, with the heavyweight tech sector leading the rebound.
The surprising resilience of the US economy has been a contributing factor to the better-than-expected performance for the US equity market. In contrast to consensus expectations that the US economy was likely to fall into recession this year, US economic performance has been much more resilient than feared. Late Q1 fears of a brewing banking crisis faded fairly quickly as economic data and earnings results surprised to the upside. At the same time, US inflation has come down despite the economy continuing to operate close to full employment. As a result, the much derided “soft landing” scenario for the US has actually been playing out so far in 2023.
In contrast to the consensus view, our base case has been that the US would not fall into recession in 2023. This has been a key reason (alongside the bullish signal from cautious investor positioning) for our overweight global equities call at the start of 2023. Our thesis has been that it would be unlikely for the US to fall into recession with a labor market operating “beyond full employment” and a household sector still sitting on a significant excess savings pool.
There still appear to be plenty of commentators who are hanging on to the recession call, but the timing has been pushed out until next year. From our perspective, the US labor market is softening from ultra tight levels and the US consumer is now a fair way through their excess savings pool, so the potential for a significant weakening in US activity is building up behind the scenes. However, we continue to see a genuine recession as unlikely over the coming year.
We think widespread labor retrenchment is unlikely to take hold, while real wage growth over the coming year will cushion the consumer slowdown. Nevertheless, we continue to watch the US economy closely.
Is the US Economy at Risk of Being Too Hot?
While a number of economic commentators are holding onto their US recession view, a run of strong data has once again raised some concerns about the US economy actually being too strong. This is raising concerns that the Fed may have to tighten further or at least delay the potential for rate cuts next year.
While recent data has been on the strong side, we struggle to see the US reaccelerating on a sustained basis. Labor market data suggest the economy is gradually cooling and the consumer balance sheet is not as robust as it was, so the risk of very strong growth over coming months is fairly low. As a result, while we push back against the notion that the US is sliding into recession, we also push back on the “no landing” scenario. A slow down to a soft landing remains our base case, and that should be a supportive backdrop for both equities and bonds.
AI Valuation: Hype or Earnings Reality?
At a more micro level, market excitement around the economic and earnings potential from the artificial intelligence (AI) revolution has been a key factor in turbo charging the US stock-market via the heavyweight tech sector. Questions have been raised as to whether the market’s AI exuberance is rational.
It seems the argument that the US market is vulnerable has in many cases shifted from underweighting the US on a recession risk call, to arguing the US should be underweighted because it is overvalued. The US multiple has pushed up again from its October 2022 lows, led decisively by the resurgent tech sector. However, we note earnings estimates have been revised up, led by the tech sector. Rather than being a long-term hypothetical, AI is already having a significant positive impact, helped by a better-than-feared economy and renewed focus on cost control.
The US market is not as cheap as it was at the start of the year, and on this basis, prospects for the next 12 months are unlikely to be as good as this year. However, considering the quality of stock that dominates the US market, we do not see 19x as excessive. The US market remains in the fair value zone in our view.
Bond Yields Push Higher against the Consensus View
While institutional positioning toward global equities was on the cautious side at the start of the year, investor positioning toward bonds was relatively bullish. Once again, this positioning appears to have been premised on the view that US recession risks for 2023 were high.
Contrary to investor expectations, economic resilience, significant US bond issuance and overweight positioning itself have combined to push US bond yields higher rather than lower this year. Australian yields have also moved up this year, albeit not as significantly.
So, once again the consensus appears to have been on the wrong side of things, although the drag from bond investments in 2023 is nowhere near as severe as it was in 2022.
Our own view on fixed interest started the year at neutral. We recently moved to overweight, with long-term yields above 4% in the US and Australia looking attractive in our view.
We do expect yields to drift lower as the economy and inflation slows further, delivering a decent mix of yield and capital gain to investors over the coming year. There is, of course, a risk to markets if US yields keep squeezing higher. Equities have been relatively resilient to the backup in yields in recent months, but the most recent leg has started to weigh on equity market performance. US inflation will be another key signpost.
China’s Economic Revival Falls Flat
From an economic perspective, China has been the big disappointment this year, with its post-Covid recovery surge proving very short lived. So far, the financial and commodity market implications of China’s economic underperformance have not been huge. Chinese equities have been lack-luster, which has dragged on the emerging market (EM) benchmark, but strong performance in other EM stock-markets has cushioned the impact.
From a commodity and resource sector perspective, the impact has been surprisingly moderate so far this year. This stands in contrast to other periods of weak Chinese growth. Perhaps this is because investors/speculators are still pinning their hopes on significant economic stimulus.
The property sector is proving the big drag on economic growth both directly and by impacting general consumer confidence. Policy settings are moderately expansionary but there has not been any dramatic policy intervention, at least so far. Authorities continue to drip feed support into the economy incrementally.
Is China the New Japan?
While numerous comparisons have been made recently, China is unlikely to move into a stagnation phase, as happened to Japan around 1990. It may be an issue for China down the track, given long-term demographic challenges, but it is not a story for this decade in our view. Economic growth is likely to run well ahead of developed economy averages for the next 5 - 10 years. Chinese growth potential has slowed but it has not collapsed.
China is still a low- to middle-income developing country, with a gross domestic product (GDP) per capita less than 20% of the US level, while Japan was already a highly developed economy in 1990, with a GDP per capita exceeding the US level. This suggests China still has significant room to grow compared with Japan in 1990. At this stage of development, China’s urbanization is still incomplete and its per capita capital stock is still low.
China still has significant capacity to upgrade its industries with technologies and more advanced capital equipment. As a result, we expect China’s potential GDP growth to average 4%+ a year in the 2021-2030 decade, with potential growth initially close to 5% before falling to about 3.5% by the end of the decade. This certainly marks a significant slowdown compared with the 10% average annual growth in the 2001-2010 decade, and the 7% growth of the 2011-2020 period, though it highlights China’s significant growth advantage versus the developed world.
On this basis, we are willing to take a somewhat contrarian and patient view on EM equities. We are attracted to the very cheap valuation on offer in China and the broader EM opportunity set.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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