What to buy in 2023: a good year for income investing

Given economic forecasts for the next 12 months, this City expert is already calling 2023 the ‘Year of Yield’. Here’s where they expect the best investment returns to be.

Next year will be the ‘Year of Yield’, a leading City bank has forecast as “exceptional” conditions create potential in assets ranging from European banks to emerging markets.

Morgan Stanley’s prediction of a good year for income investing is built around next year’s outlook of slower growth and inflation and pause in tightening by central banks.

This means assets that are more sensitive to rate uncertainty are likely to bottom first, supporting high-quality income such as high-grade bonds and US defensive equities in staples, healthcare and utilities.

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The bank also favours value plays in Europe, where stocks in the banks and energy sectors offer above-average dividend yields.

It adds: “We think that this is an exceptional environment for generating high single-digit returns from high-quality assets, an opportunity that hasn’t presented itself for a long time.”

The City firm’s 2023 look ahead highlights the potential of buying early cycle emerging market and Japan equities for 11-12% returns.

Morgan Stanley said: “Valuations are clearly cheap and cyclical winds are shifting in favour of emerging markets as global inflation eases quicker than expected, the Federal Reserve stops hiking in January (and starts cutting in Q4), and the US dollar rolls over.”

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If global growth troughs as expected in Q1, domestic demand resilience means Asia is likely to be at the forefront of a recovery. In contrast, the S&P 500, cyclicals and metals are forecast to trough later as confidence in growth takes more time.

The bank points out that the MSCI emerging markets benchmark typically outperforms in early cycles, leading to its forecast of 12% price returns in 2023 and 11% for Tokyo’s Topix.

“Equities are forward looking”, says the broker, “even in bear markets, and typically trough 3-6 months before the economy – i.e., over the next three months or so, given our economists' view of a second half 2023 recovery.”

The analysis comes after the broadest tightening of global central bank policy since at least 1980. If the year ended today, Morgan Stanley points out that 2022 would be the first year that US stocks and long-term bonds are both down more than 10% in the last 150 years.

It said: “The losses of 2022 make it tempting to look back – in awe, in frustration, in anger. Don’t. We expect 2023 to look different for the economy and markets.

“Growth will be worse, inflation will be lower, and cross-asset returns – especially in fixed income – will look much better. Cheaper starting valuations, wrought by this year’s poor performance, are a big part of this story.”

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Morgan Stanley admits there will be scepticism over an inflation peak, but says the reversal of base effects in food and energy, moderation of goods consumption and discounting caused by high inventories are reasons to support this expectation.

The bank’s base case is that a deeper global slowdown arrives early in 2023 as Europe goes into recession, China waits until spring to end Covid-zero and the US barely skirts recession as housing activity plummets.

It said: “The silver lining is that this weakness is short and shallow; global growth bottoms around March/April, and improves thereafter.”

However, the analysis also highlights a bear case reflecting recession, geopolitical tensions and liquidity apprehension created by quantitative tightening.

It said: “Soft landings, where central banks tighten meaningfully without a recession, are rare. In our bear case, the US does fall into recession, Europe’s recession is more severe, and China reopens more cautiously.”