With markets having enjoyed a solid start to 2023, investors have become more optimistic about equities and bonds. While there are good reasons to be more upbeat, it’s important to understand what could go wrong as well as right in the months ahead.

Markets are up because investors believe inflation is at, or close to, its peak. Commodity prices such as oil and natural gas have pulled back from their 2022 highs, and there is hope that central banks are near the top of their interest rate rise cycle.

These factors have led investors to become more ‘risk on’ with their investment choices. Companies with both good and bad news are rising, yet at some point soon the market could pay more attention to fundamentals such as sales and profits, so don’t assume the rising tide is going to keep lifting all boats.

If US earnings forecasts are wrong (too high) then we could see another wobble on the country’s major indices like the S&P and Nasdaq because valuations in that region remain elevated. ‘US stocks are trading on 18 times earnings now, versus a 15.7-times average,’ says Richard Champion, deputy chief investment officer at Canaccord Genuity Wealth Management. He is one of several investment experts who are cautious about the US near-term but see merits longer term. ‘After all, US firms are more profitable and have stronger growth than many other parts of the world,’ adds Champion.

Andrew Hardy, investment director at Momentum Global Investment Management, also takes the view that having exposure to the US in a portfolio is wise on a longer-term basis as the region offers a ‘broad, deep universe’ of stocks. However, he is worried the US is currently further behind in terms of economic contraction and has an underweight position to the country in his portfolios.

Investors have been keeping a close eye on the impact that higher interest rates are having on consumers and businesses. While the UK has so far avoided being in a technical recession (two straight quarters of negative growth), the latest CPI figures from the US show high inflation is proving to be stickier than many people thought.

Markets are expecting the Federal Reserve to raise US rates a bit further and cut by the end of the year. Hardy says failure to see a rate cut in 2023 is less of an issue to equities than if the Fed keeps raising rates.

This potential scenario is a key reason why many investment experts still prefer ‘jam today’ value stocks rather than ‘jam tomorrow’ growth ones, even though the latter have started to rally after a miserable time in 2022.

The UK and Japan stand out as attractive places to find value stocks, particularly because so many investors dislike these regions. In reality, FTSE 100 companies have proved to be fairly robust while Japanese firms are paying more attention to running their business for profit and increasing shareholder returns including dividends.

‘Investor sentiment is negative towards the UK and Japan yet buying cheap assets when there is fear and pessimism is often a good long-term move,’ says Hardy. I’m inclined to agree.

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