Market round-up: It’s all about balance

The Backdrop

Recent years have been tumultuous. In 2020, we faced a global pandemic and lockdown, followed by slow reopening of economies in 2021. 2022 started off with great promise with the economy riding a V-shaped recovery, and the S&P 500 hit an all-time high in January. However, as the Great Moderation came to an end, the blissful extended period of stable activity and inflation made way for a new regime of greater macro and market volatility. The resultant reset in valuations made for one of the worst ever years for balanced portfolios as both stocks and bonds suffered significant losses, leaving traditional investors with no haven.

The economic challenges that dominated 2022, from elevated inflation sparking an aggressive global rate hiking cycle, to Russia’s illegal invasion of Ukraine and ensuing energy disruptions, along with China's weakening growth, weighed heavily on the investment outlook going into 2023.

Resilience across the board

The first quarter (‘Q1’) of the year defied expectations with robust global growth, a mild winter, sustained consumer resilience, leading to a newly buoyant business sentiment boosted by China's reopening. This positive momentum defies expectations of a looming recession, potentially pushing it back to the second half of the year.

The markets started off the year strong, as equities and fixed income surged in January driven by lower inflation and the prospect of easier monetary policy. However, in February, strong economic data and sticky core inflation forced investors to reassess their expectations and factor in higher-for-longer interest rates. During the Q4 2022 earnings season, both the EU and the US saw lower-than-average earnings and revenue beats.

The collapse of Silicon Valley Bank and the potentially unlawful arranged marriage of Credit Suisse to UBS followed in March leading to a major sell-off in financials taking a toll on value stocks. Nonetheless, stocks remained steadfast, with EU stocks surging over 10% in Q1, outperforming the S&P 500, which had plummeted 20% in 2022, but managed to climb 7.5% in Q1.

Big Tech mega caps, led by star performers NVIDIA (91.3%) and TESLA (91.9%), charged ahead, with just 7 names contributing to 90% of S&P returns and driving the Nasdaq 100 up by 20%. Meanwhile, long-dated government bonds outperformed corporates, providing the highest returns in both the US (6.2% vs 5.5%) and the EU (4.3% vs 3.3%). However, the dizzying volatility in the 2-year yield curve, as demonstrated by the MOVE Index, made it increasingly challenging to anchor policy and value fixed income.

The fight against inflation

Despite easing over the quarter due to low energy prices and falling goods prices, headline inflation remains significantly above the central banks’ medium-term target of 2%, standing at 6.9% and 6% for the EU and US, respectively. Tight labour markets leading to persisting wage growth is driving the services component to fuel stickier core inflation, which reached a new high of 5.7% in the EU and coming in at 5.5% in the US. It's clear that the fight against inflation is far from over.

Central banks continued to hike rates taking the Federal funds rate up to range from 4.75% to 5% and the ECB increasing the deposit facility rate to 3%. With hiking cycles expected to conclude in the coming months all eyes will be on central banks as they meet next in May.

Banking turmoil and Credit crunch

2023 is nothing like 2008. Banking woes have shaken confidence in the Western banking system complicating the central banks’ balancing act between inflation and growth with concerns of financial stability.

While the FED and ECB have committed liquidity to safeguard their economies and promote stability, tighter bank lending standards and rising funding costs could trigger a widespread credit contraction and economic slowdown. This is naturally deflationary.

Financial institutions are also facing challenges in trillions of dollars in unrealized losses on their balance sheets due to held/hidden-till-maturity assets while bank deposits continue to shrink as depositors flock into money market funds which at attractive yields have made "T-Bill and Chill" a popular investment strategy.

Market expectations

The current risk-on mood in equities could be the calm before the storm as headwinds from bank turbulence, oil shocks, and slowing growth threaten to dampen spirits. The return of higher-for-longer rates could quickly reverse market sentiment if inflation persists, but short covering may provide temporary support.

Assessing the level of economic damage priced-in and gauging evolving sentiment is vital for strategic positioning. The market is presently pricing in a recession that brings inflation down and keeps rates low with no significant impact on corporate earnings.

Cracks in the economy are beginning to show with warning signs from the plunging money supply, pending home sales, diminishing CEO confidence, and tighter corporate lending conditions. The FED's preferred recession indicator, the near-term forward spread in Treasury yields, is currently implying an 86% probability of a recession within 12 months. However, retail sales growth and employment remain resilient, and the reopening of China may boost the global economy.

The US bond market is pricing in multiple rate cuts in 2023. Despite the historical trend of a short period between the last hike and the first cut, the FED's pivot, whenever it comes, will hinge on the persistence of inflation.

The upcoming Q1 2023 earnings season is make or break for many companies. With a consensus estimate of an 8% contraction in the US, quality companies that can still maintain pricing power and protect margins are likely to perform well in this challenging environment.

The geopolitical backdrop also remains volatile, with several ongoing conflicts and tensions escalating. These include the conflict in Ukraine, Russia's deployment of nuclear weapons in Belarus, renewed trade tensions between the US and China, and China's military drills near Taiwan.

Getting ready for what’s next

Preparing for what lies ahead is crucial. As markets continue to rally this year, there is an increasing sense of optimism that the worst may be behind us. Despite only being three months into 2023, the market has traded within a wide range since reaching its lows last year. Given this prolonged period of uncertainty, it is inevitable that the market will eventually take a definitive direction. Corporate earnings and the liquidity environment created by central banks will be critical in establishing market consensus.

More importantly, until the lagged effects of monetary policy clearly come to the fore and structural economic and market changes materialize it is vital to maintain a balanced investment portfolio with a focus on quality within both equity and bond allocations, while managing risks in the face of uncertainty surrounding inflation, the impact of recent banking turmoil and mounting geopolitical tensions.

Against this backdrop asset allocation reigns supreme, and the ability to swiftly adapt is critical in seizing potential opportunities born from heightened volatility. After all, volatility is the only asset class.

Josef Luke Azzopardi, BOV Asset Management


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