Had investors gazed into a crystal ball at the start of 2023 they might have concluded that the investment landscape would be hard to predict this year. No surprise there.

Now, halfway through the second quarter, prospects for global markets are little clearer with persistent uncertainty and asset price volatility. That said, some analysts believe that there is comfort to be taken from improved prospects for medium-term portfolio returns following the sharp drop in valuations last year, as both bond and stock markets uncharacteristically fell together.

The major US stock markets – the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite – have all made gains so far in 2023, with the tech-heavy Nasdaq up more than 17% thanks to investor’s sharp reassessment of growth stocks right at the start of the year (Nasdaq rallied 11% in January).

The S&P 500’s more than 7% gains to date imply an annualised return of around 16% this year, if trends continue, returns that few would have dreamed possible at the start of the year. The UK’s FTSE 100 has also been robust in 2023, on track for annualised returns of nearly 10% this year, again, if current trends persist. That’s before dividends. Capital returns even close to this would be genuinely surprising with soaring interest rates significantly elevating the cost of borrowing for businesses.

Eurozone markets have been even stronger, the Euro Stoxx 50 (a collection of Europe’s 50 largest companies) is up 14% year-to-date, thanks in large part to similar rallies for German (DAX) and French (CAC) markets.

‘The switch from low interest rates over the past year has driven demand away from the growth companies and more into value stocks, and ‘that really plays into Europe, which has always been more of a value market than the US,’ says Richard Saldanha, lead manager for the Global Equity Income Fund at Aviva Investors.

WHAT’S WORKED FOR RETURNS THIS YEAR

Shares of LVMH (MC:EPA), Europe’s most valuable company worth €9.2 billion, reached at an all-time high in April after the luxury goods giant reported strong sales lifted by a rebound in China. LVMH stock has rallied 30% in 2023, while European luxury peers Hermes (RMS:PA) and L’Oreal (OREP:PA) have made similar gains.

Looking at UK sectors, it is interesting to note that financial services companies have been among the poorest performers so far this year. Why tobacco has had such a rough 2023 ride to date is nuanced, given it is effectively just two companies – British American Tobacco (BATS) and Imperial Brands (IMB), but that commodity stocks have struggled, or industrial metals, as the UK sector is called, should not be so surprising.

Key commodities from crude oil to copper and iron ore started 2023 with strong gains in the belief that a post-pandemic recovery in China, the world’s top consumer of raw materials, would more than offset darkening economic clouds in Europe and the US. Yet some believe that China’s reopening was not strong enough ‘to offset the negative impact of rising rates,’ particularly following the Fed’s positioning and what markets could see as ‘recession by design, or the Fed prepared to take aggressive action in order to cool inflation, no matter the economic impact, meaning higher rates and for much longer than previously anticipated,’ says Ole Hansen, head of commodity strategy at Saxo Bank.

Copper prices, for example, has been supported by rising demand from electrical vehicles, renewable power generation and energy storage and transmission, but that rally has run out of steam.

Copper prices tend to be seen as proxy for economic expansion in a comparable way that rising gold prices imply nervousness, and sharp falls over the past month of the former, and near record highs for the latter act as an indicator of investor caution and recession concerns.

FINDING THE RIGHT BALANCE

One of the key challenges for investors now is balancing the relatively strong current environment in developed markets with various medium-term risks, what Berenberg analysts are calling ‘the
great divergence.’

‘For instance, the US ran a far more expansionary fiscal policy than Europe in the early stages of the pandemic, and although major regions influence each other, the outlook for the post-shock performance differs from region to region,’ says Berenberg. ‘By 2024, more normal patterns may re-assert themselves with less divergence in growth between the US, China and Europe,’ yet this outcome is far from guaranteed.

‘Economic conditions have so far been resilient in the US – employment gains support consumer spending, but the economy is losing momentum in response to Fed tightening,’ Berenberg says. ‘Banks are also tightening credit standards in the wake of banking tremors and in anticipation of stricter regulations. This points to a mild recession, but sustained growth in consumption and stabilisation of housing may offset a decline in business investment and avert a fall in real GDP,’ say the investment bank’s analysts.

US economic chatter more recently has focused on concerns about the nation’s debt ceiling and the prospect of an unheard-of default on US bonds. Default has never happened before and could push the US and global economy into harrowing territory, economists say.

Default looms by June so talks around raising the $31.4 trillion ceiling are urgent and failure to find an agreement is clearly worrying for financial markets. Yet US lawmakers have been here before and have previously knocked heads and been able to pull an 11th-hour rabbit out of the hat.

In contrast to the US banking crisis, China’s bank stocks have rallied in recent weeks on news that Beijing will allow state-backed firms to access more capital. This rally has started to fizzle out, however, after trade data for April showed imports shrank and export growth slowed.

PUBLIC ENEMY NUMBER ONE

Clearly, inflation is still too high and too sticky for policymakers to relax and it remains public enemy number one for central banks. ‘We still expect a recession in the US and Europe within the next 12 months,’ says Eugene Philalithis, head of multi-asset management, for Europe at Fidelity.

‘Both the Fed and the ECB have tightened monetary policy significantly, the effects of which are still yet to be fully realised.’

Bond yields support the recessionary scenario. ‘Within fixed income, we prefer to allocate towards higher quality and more defensive government and investment grade bonds and away from riskier high yield debt,’ say Canaccord analysts.

They are allocating away from corporate credit, as credit conditions continue to tighten in the aftermath of banking sector stress and loan markets are seeing rising rates of distress. ‘We prefer UK Gilts over Bunds (German bonds) and JGBs (Japanese bonds) as inflation dynamics soften as opposed to the more hawkish ECB.’

Sentiment has been supported in recent weeks by the fact that a 2008-style financial crisis looks much less likely than it did when Silicon Valley Bank collapsed in March. ‘Silicon Valley Bank became the poster child for a very old kind of panic, one in which depositors lost faith in the bank and made for the exit all at once,’ explains Saxo’s chief investment officer, Steen Jakobsen.

Unlike the Great Financial Crisis, ‘this banking crisis is not about the solvency of banks, but whether the banks can continue to operate profitably if funding costs rise,’ Jakobsen says.

Yet jitters in the banking sector have accelerated financial tightening, and Philalithis says his Fidelity team are watching closely to understand the impact of this across markets. ‘The hit to confidence in the financial sector will reverberate through the rest of the US economy and adds to a growing number of macro headwinds,’ he says.

Inflation prospects may be improving but the outlook is still uncomfortable, and key questions remain unanswered. How long will inflation drag on economic and market sentiment? How quickly can central banks get inflation back to their long-run goal of around 2%, and how will these factors influence interest rates decisions through the rest of 2023?

‘We don’t yet know what that comfort level for central banks will be, although we suspect it will be higher than their own 2% annual targets,’ say analysts at Canaccord Genuity, so what this might mean for the 2023 inflation forecasts is also not clear.

WHAT ELSE WILL MARKETS BE WATCHING?

‘The US is clearly slowing down towards “stall speed”, with a range of conflicting factors influencing economic growth, and we expect very slow or no growth for the rest of the year,’ say Canaccord’s analysts.

We have already seen recessions in those sectors most sensitive to rising rates, such as housing, and those susceptible to weakness in the face of US dollar strength, most obviously manufacturing and certain exports. For now, the US consumer is still in fine health, with some lingering savings from the pandemic available and a tight jobs market providing confidence.

How long those powerful factors behind consumption will persist is open to question and will be monitored closely.

China is emerging from its zero-Covid policy far faster than expected, accompanied by a broadening package of growth-positive policy announcements. Many other emerging markets are benefiting from falling inflation, peak monetary tightening, and attractive valuations, believes Fidelity’s Philalithis.

This may prove a potent mix, despite global headwinds. ‘We think the recent pause in China’s reopening rally is temporary, and improving corporate earnings are likely to take over from cheap valuations as the main driver in the next stage of the rebound.’

Corporate results have so far demonstrated largely robust revenue growth in a world of high nominal economic growth, but profit margins are struggling under the weight of rising labour costs and elevated input pressures. This trend might not reverse as quickly as some hope, which suggests that investors would be wise to remain wary of relatively optimistic earnings forecasts, and the implied valuations based on these expectations.

FINAL THOUGHTS FOR INVESTORS

Analysts and market strategists seem to increasingly believe that we are in the middle of a change in basic assumptions, where structurally higher price pressures will be driven by changing global supply chains and the costs of climate change. Yet it is not clear how quickly these pressures will become apparent or when they might begin to outweigh more cyclical economic factors.

‘What is clear to me is that idiosyncratic fundamental factors are likely to play a bigger part in driving securities prices than they have over recent years when macroeconomic factors such as discount rates far outweighed company specific developments,’ says Ronald Temple, chief market strategist at investment bank Lazard.

In a world of uncertainty, questionable economic forecasting, and known unknowns around inflation and interest rates, it is a natural reaction for investors to be suspicious of many investments. Surely, if risks abound in the macroeconomic backdrop, investors should avoid riskier investments.

But that is not what market wisdom suggests, in our view. Often, the best investment decisions are those that feel most difficult to make. Better to keep things in simple terms; how much does any investment cost relative to its long-term potential worth, and what is everyone else doing?

Canaccord sums it up as ‘a bit like buying a house, when the worst time to do so is when prices have risen quickly in a short space of time, but everyone still wants to buy houses’.

So where are we today? ‘In a sense it is a Goldilocks scenario, where things are neither too hot nor too cold, but great for pursuing a balanced and diversified approach with your investment strategies.’

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