Our City expert discusses the key investing themes for the months ahead and the odds of a recovery in share prices at some point next year.
Forecasts for 2023 point to investors having to ride out more stock market storms as inflation begins its tricky path to normalisation and the strain of higher interest rates kicks in.
The recessionary outlook created by 2022’s rapid rise in borrowing and energy costs means defensive and value stocks are likely to remain key investing themes for the time being,
But the consensus view is that the second half of 2023 may be better, particularly if markets follow the “recession playbook” of bottoming less than halfway through a downturn.
However, much will hinge on the pace of disinflation, how long it takes the US Federal Reserve to signal an interest rate peak and for China to fully relax its zero Covid policy.
For now, Morgan Stanley and several other City banks believe there’s more “wood to chop” in the downgrade cycle and that 2023’s starting valuations fail to fully account for the extent of the earnings hit from the slowing global economy.
Bank of America, for example, pointed out recently that Wall Street’s estimates for S&P 500 earnings per share are 15% above its own.
Stock market optimism has built since October’s weaker US inflation print fuelled hopes the Federal Reserve is near the peak of its hiking cycle. This led investors to take new cyclical positions, possibly in “fear of missing out” on the start of a stock market recovery.
UBS’ chief investment officer Mark Haefele believes that markets have moved too far too fast: “We do not see this as fully reflecting the drag on growth imposed by prior tightening.”
The Federal Reserve provided a reality check for markets just before Christmas when all but two of 19 US policymakers forecast a target for the Fed funds rate above 5% next year, compared with the year end level of 4.25%-4.5%. This contrasted with the much more optimistic Wall Street view of below 5%.
The European Central Bank added that the fight against inflation is far from over when it signalled at least another one per cent of rate hikes by the spring.
Bank of America believes investors would do well to focus on the “marathon not the sprint”.
It added: “In the near term, pain from earnings per share cuts is likely. But the best phase is that which follows - low but rising earnings revision ratios.
“The market typically bottoms six months before the end of a recession, so buy in the first half based on our economists forecast of the recession ending by the third quarter of 2023.”
Its base forecast is for the S&P 500 index to recover to 4,000 by the end of 2023, but with a bear case of 3,000. UBS added recently that stocks are pricing in only 41% and 80% probabilities of a recession in the US and Europe, respectively.
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The Swiss bank has forecast a bottom of 3,200 before an improving rates outlook from the summer onwards triggers a recovery to a year-end 3,900.
The mood towards UK assets has improved since the shock of the unfunded tax cuts in September’s mini-budget, with sterling improving from a low of $1.03 at the end of that month to close the year in the region of $1.20.
Despite this rebound, many traders in the City remain sceptical and think a sustained improvement in sterling is only likely when inflation is shown to be under control.
There’s huge uncertainty about how fast the inflation rate will fall back from the current 10.7%, with a recent survey of market professionals by Deutsche Bank finding that most fear high or very high stagflationary risks in the UK over the next three to five years.
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Capital Economics believes that wage growth will force the Bank of England to raise interest rates by another 1% to a peak of 4.5% and that the recession will be deeper, involving a decline in real GDP of 2% rather than the 1%-1.5% seen in the City.
Its chief UK economist Paul Dales added: “While we think a bigger recession will mean the Bank will eventually cut interest rates by more than the markets have priced in, we think that’s a story for 2024 rather than for 2023.”
He notes that a whole myriad of overseas developments could mean the performance of the UK economy in 2023 is better or worse than expected. On the positive side, Dales said these included a further easing in global supply shortages, a smooth ending to zero Covid in China and an end to the war in Ukraine.
The negatives could be debt crises in some emerging markets, an intensification of global fracturing and bigger and sharper declines in house prices.
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