Global outlook: Difficult year set to follow rotten year

Market participants expect 2023 to be an improvement on the year just ended, a low bar to clear after central bank tightening to choke off rampant inflation crushed stock and bond valuations in 2022.

Just how improved will depend on how long it takes the U.S. Federal Reserve — which boosted its key federal funds rate last year to between 4.25% and 4.50% in December from 0% to 0.25% in March — to signal a looming end to its rate hiking cycle.

"Markets, arguably, are going to be a little bit better" in 2023, mostly on the strength of higher bond market returns, even as the macroeconomic backdrop in the U.S. and Europe worsens, said Paul Kalogirou, Hong Kong-based head of client portfolio management, Asia and global multiasset solutions, with Manulife Investment Management. How the Federal Reserve reacts to that economic slowdown will determine whether a broader range of risk assets will be gaining ground as the coming year ends, he said. As of Sept. 30, the Toronto-based money manager reported C$801 billion ($588.2 billion) in assets under management.

Some asset management houses are relatively optimistic on that score.

"Our base case is inflation comes off the boil relatively quickly," allowing the U.S. Fed to turn its focus to growth, said Michele Barlow, Hong Kong-based head of investment strategy and research, Asia-Pacific, with State Street Global Advisors.

SSGA's report on the coming year, "Navigating a Bumpy Landing," predicted the Fed could begin cutting rates as early as the fourth quarter of 2023. Boston-based SSGA reported AUM of $3.48 trillion as of June 30.

That timing would be consistent with "some kind of risk-on scenario" in the second half of the coming year, Ms. Barlow said in an interview.

Others contend the hurdle for any Fed easing in 2023 will be high.

That can only happen "if the medicine the Fed is currently prescribing is working," inducing a sharp slowdown or a recessionary environment from the first half of the coming year, said Sonja Laud, London-based chief investment officer with Legal & General Investment Management. LGIM reported AUM of $1.6 trillion as of June 30.

The focus of the economic landscape will inevitably "shift somewhat" from inflation risk to recession risk as the coming year progresses but inflation is likely to remain high, "given that wage growth is not moderating," said Saira Malik, San Francisco-based chief investment officer with Nuveen LLC, the New York-based asset management arm of TIAA-CREF.

"Our expectation is that the decline (in headline inflation) will be more gradual than what is currently priced in," agreed Jon Pliner, New York-based senior investments director and U.S. head of delegated portfolio management with Willis Towers Watson PLC.

That could prove a stumbling block for a Federal Reserve intent on re-establishing its inflation-fighting credentials after insisting, when price pressures first emerged in 2021, that they were likely to prove transitory.

"The Fed has been clear — and we believe them — that they are going to keep policy rates high for an extended period through 2023," said Erik Knutzen, managing director and chief investment officer – multiasset class with New York-based Neuberger Berman Group LLC.

Equity market valuations have yet to fully reflect that prospect, despite widespread expectations that the U.S. economy, along with the U.K. and Europe, will fall into recession early in the new year, money managers said.

"The market does not yet believe the Fed" and it probably should, said Mr. Knutzen. Neuberger Berman had AUM of $401 billion as of Sept. 30.

Against that backdrop, some market veterans warn that signs of exuberance, irrational or not, could delay Fed easing. "The more relief rallies we have, the longer it's likely to be, because they want to really tighten conditions," said Virginie Maisonneuve, London-based global CIO equity with Allianz Global Investors. AGI reported AUM of €521 billion ($554.9 billion) as of Sept. 30.

For now, said LGIM's Ms. Laud, equity markets appear to be pricing in a soft landing "and we are very cautious that this might be a bit premature," raising the prospect of more downside during the coming year.

Andrew Pease, Russell Investments' London-based global head of investment strategy, said he has concerns about potential downside in 2024 as well if a so-called soft landing by the Fed in 2023 allows inflationary pressures to continue simmering just below the surface.

On a potential "Goldilocks" scenario, he said: "You get the slowdown to, say, 1% growth or half a percent growth, the unemployment rate goes up by about a percentage point and inflation comes back down with a 2 in front of it." While possible, "a lot of things would have to go right for that case to play out," he said.

If, instead, inflation were to drop to a percentage point or two above the Fed's 2% target, pushing up real incomes in a way that causes consumer spending to accelerate, the central bank could have to resume tightening toward the end of 2023 — well after the first quarter pause in the rate hiking cycle many market participants now expect — and lift the fed funds rate toward 6%, Mr. Pease predicted. That could result in a significant recession in 2024 that would overshadow the shallow, brief downturn widely anticipated now for 2023. Mr. Pease said that scenario, while unlikely, is perilous enough to merit concern.

Complicating the outlook now is an especially daunting environment for making forecasts, market veterans said.

Russell's base case is for a recession in 2023 but "this has been such a different cycle on so many different levels that it's very, very hard to predict," Mr. Pease said.

"We're all looking at the same indicators" — the biggest tightening since former Fed Chairman Paul Volcker, the yield curve as inverted as it has been since the 1980s, the Institute for Supply Management index is now below 50, which are all recession precursers but "we're coming out of this most unusual economic environment ever," the Russell veteran noted. Maybe the ISM, focused on goods, is "not the best indicator" at a moment when demand for services is playing catch up following a pandemic surge in goods purchases, he said.

Forecasting, difficult at the best of times, is particularly challenging now in an environment dominated by potential tail risks, including the Russia-Ukraine war and China's pandemic reopening, said LGIM's Ms. Laud.

For example, a peace deal in Ukraine would cause gas prices to plummet and U.K. and European stocks to go through the roof — a challenging consideration to integrate into a normal, fundamental analysis, Ms. Laud noted.

"We're particularly looking at the reaction function of the labor market" — how interest rate changes could impact a labor market coming out of two years of pandemic lockdowns, Ms. Laud said. Such an analysis could hold the key to forecasts on interest rates and recessions, she added.

In the U.K., meanwhile, nurses, train drivers, postal works and border control employees have all gone on strike in the span of a week — an unprecedented wave that needs to be watched closely because strong wage increases could add to price pressures that central banks will have to address, she said.

"You would watch the labor market … because we would need to see unemployment rise in order to have a clear tick in the box that the medicine is working," Ms. Laud said.

As the new year begins, a critical mass of uncertainty will continue to dog investors pining above all for clarity, leaving many in wait-and-see mode for now.

Mr. Kalogirou said Manulife Investment Management's $128.4 billion multiasset solutions group is maintaining a neutral equity position for now. "We don't necessarily see high conviction on sustainable rallies from here if the Fed remains where it is, nor do we see high conviction on rallies from here should earnings be downgraded," he said. If the Fed makes it clear it's ready to pause rate hikes or opens the door for cuts, "that would change our view toward adding risk," Mr. Kalogirou. "But at this point in time, it's a year for risk management."

Private market investors are in a similar state of mind.

Amid the blizzard of factors impacting the investment world in 2022, Hong Kong-based private equity boutique VMS Group decided not to launch its "fund III until maybe the middle of (2023) because we need clarity" and more visibility on the firm's target markets of China and Hong Kong, said Marko Tutavac, managing director.

With the tidal wave of capital that buoyed private market asset segments for much of the past decade receding now, Mr. Tutavac said the 25% to 30% internal rates of return of recent years should prove much harder to come by for the next few years. But if the environment for the first half of 2023 looks set to remain challenging, he said he remains cautiously optimistic about the second half.

VMS reported AUM of $4.2 billion as of Nov. 30. Its third fund could look to raise between $250 million and $300 million.

If recession remains a cloud on the horizon, though, many money management executives see only limited fallout for investors at this point.

Douglas Foreman, Los Angeles-based chief investment officer with small and midsized U.S. equity boutique Kayne Anderson Rudnick Investment Management LLC, said while the mix of higher rates, high inflation and slowing growth will likely spell a mild recession in 2023, stock market valuations already largely discount that prospect. Kayne Anderson reported AUM of $45.2 billion as of Sept. 30.

If the Fed's rate hiking plans remain front of mind for market participants, the return to an environment characterized by "a real actual cost of capital instead of free money, higher risk-free rates, a real term premium in bond markets and increased credit and equity risk premia" following a decade or more of extraordinary monetary policy stimulus should prove a bumpy, volatile multiyear transition, predicted Neuberger Berman's Mr. Knutzen.

LGIM's Ms. Laud agreed: "We've lived through the most accommodative monetary policy regime" ever over the past 10 to 15 years so the assumption that one rate hike cycle would kind of normalize everything is wrong. "It will take a lot longer for us to get to a more normalized market environment," Ms. Laud added.

Meanwhile, with investors now living data point to data point, markets will likely remain highly volatile, money management executives said. "We and the central banks will watch every incoming data point to judge and read how efficient the rate hike cycle will be in closing down the economy, (and) the market will react very, very short term and strongly ... should the data support the view of the medicine working or not," Ms. Laud said. With 2022 in the rearview mirror, leading stock market indexes suffered some of their worst losses in more than a decade. Both the S&P 500 and the MSCI ACWI ended down roughly 20% for the year and market veterans note that those losses, for the most part, simply reflect the rise in interest rates rather than the earnings downgrades that are sure to come as monetary tightening slows the economy.

"It's going to be very volatile and we strongly believe that there's another leg down in equity markets," Mr. Knutzen said. But "at some point there's going to come a time to re-risk portfolios and those inflexion points are extraordinarily challenging," he added.

Meanwhile, in what could prove a prelude for the market-moving power of coming Fed policy shifts, an unexpected monetary tightening by the Bank of Japan in late December effectively reduced the attractions of a Japanese market that global managers were predicting would garner considerable interest in 2023.

The BOJ announced on Dec. 20 it would allow 10-year Japan government bond yields capped at 0.25% since 2016 to rise to 0.50% — a move many observers saw as more likely after the anticipated departure of BOJ Gov. Haruhiko Kuroda, the architect of the central bank's yield curve control policy, following Japan's March 31 fiscal year close. In Dec. 20 trading, the yield on the benchmark 10-year Japanese government bond jumped to a multiyear high of 0.417% from 0.256% the day before, while in currency markets the yen strengthened to 131.70 to the dollar from 136.91 to the dollar the day before.

Neuberger's Mr. Knutzen, who earlier in December had cited Japan's attractions as "the last major economy where both the central bank and the fiscal side are stimulative," with a very cheap currency to boot, said news of the Dec. 20 tightening has prompted his firm to move from "an overweight position" in Japanese equities to a more neutral exposure. Neuberger remains overweight the yen and underweight JGBs. On the equity side, with the evolution in Japan's policy stance, the firm will focus more on domestically oriented companies, relying on active management to pursue attractive opportunities as policy adjusts, he said.

If equity markets face a mixed outlook, the sharp hike in rates from rock-bottom levels over the past year has positioned bond managers as the asset management industry's comeback kids in 2023.

As yields rose during the second half of 2022, and particularly in the fourth quarter of the year, there's been a "reappraisal of the benefits fixed income has to offer," said Andy Burgess, fixed-income investment specialist with Insight Investment, a London-based money manager with €778.3 billion ($819.6 billion) in assets under management.

"We're starting to see money come back in toward fixed-income assets generally, and in particular corporate debt where investment-grade and high-yield spreads are much, much more attractive," Mr. Burgess said.

Other managers likewise report renewed interest in fixed income.

The biggest shift for Neuberger Berman's multiasset team over the past six months has been becoming more constructive on fixed income, Mr. Knutzen said. While underweight bonds and duration in the first half of the year, since the third quarter, "after rates had moved up dramatically and spreads had widened, we began neutralizing that underweight position in duration, buying short-duration high quality credit and going relatively overweight fixed income compared to equity," he said.

Edward Perks, San Mateo, Calif.-based chief investment officer of Franklin Templeton's income investors unit, said his team boosted its portfolio's fixed-income allocation to 55% by the end of November from 31% at the end of 2021, with a corresponding drop in its equity allocation to 41% from 65%.

Mr. Perks said his managers parked the proceeds from selling relatively resilient defensive stocks in cash and short-term Treasuries as "dry powder" to fund the transition to fixed income as rapidly rising yields resulted in evermore attractive valuations for bonds.

Meanwhile, if the question of whether the Fed, as expected, stops hiking its fed funds rate at 5% or goes higher is a make-or-break proposition for equity investors, managers said that uncertainty shouldn't cause bond investors to lose sleep.

At current yields, a lot of bad news about expected rate hikes is already priced in for bonds, something that equity investors now can't say, Insight's Mr. Burgess noted.

"If times are good, then (bonds) are offering you an attractive yield. If times are pretty horrible and growth is much, much slower and the Fed cuts rates, well, they'll be offering you a pretty good return there as yields fall," he said. Equity markets, by contrast, are a lot more vulnerable to a correction going into next year if growth slows materially, he added.

Palash Ghosh contributed to this story.