Higher for longer, or how 2023 may turn out a good year for growth strategies

Seeing the light at the end of the tunnel

2022 was a bloodbath year for most of our thematics. The ones escaping the most severe sell-offs (at the time of this writing) were Bionics and Sustainable Future, down low double-digits. Commodities and cash were the best-performing asset classes in what Deutsche Bank described as the worst year in the financial markets since 1788.

At the end of 2021, we had written that inflation concerns were to ease during the second half of 2022 and that FED's monetary policy would be more favorable going into year-end. We also failed to see the Ukrainian situation erupting into a conflict. We couldn't be more wrong on these statements. Inflation continued its steep upward momentum throughout 2022. In the first FOMC meeting of the year (26 January 2022), the FED set the tone for the year by stating that it would disregard markets and focus on "fighting inflation." At that time, we thought the FED wouldn't tighten as much, as we expected inflation to slow down together with GDP growth. But after a weak first half, U.S. GDP turned out to be much stronger than anticipated in the 2H. Inflation, in the meantime, continued to rise. 

We believe that going into 2023, the first FOMC meeting (31 January 2023) might set the tone for the year again. The FED has made clear reining in inflation is its priority target. This historically happens only after Fed Funds reach or exceed the core CPI level. The markets anticipate Fed Funds rates reaching 5% early next year. Inflation is expected to cool down over the coming months, and if that proves correct, the FED should stop its interest rates tightening cycle at the end of 1Q23. A strong economy may delay the cooling down of inflation and push the FED rates slightly higher: the "higher for longer" risk. 

The yield curve started to invert in July 2022, when the spread between the 10-year and 2-year yields became negative. We are now at the steepest spread (-0.78%) of the last 42 years. Inversion of the yield curve usually signals a recession ahead. Recessions typically begin 12 to 18 months after the first hike, which implies a possible start by June 2023. Markets are bracing for the ensuing revenue and earnings negative revision. The "higher for longer" risk implies a positive surprise for earnings into the 1H of the year, which would be supportive for stocks. 

We also know that the equity market bottoms well before (usually six to nine months) GDP and earnings. The main unknown is thus how deep the recession may be if a downturn in the U.S. eventually takes place. But in the "higher for longer" scenario, having had time to rein in inflation adequately, the FED would also have plenty of ammunition to tackle the economic slowdown, which will be music for the ears of equity investors. 

Different regions, different dynamics

Some (involuntary) help for the FED may come from China. 

During the financial crisis of 2008, China (and Asia overall) acted as a backstop to the world's financial and economic crises. Its economy was growing strongly, driving demand worldwide. At that time, China accounted for only 7.2% of the world's GDP vs. 18.4% today. The Central Bank of China is currently (something we already wrote about in the past) the only central bank in the world with the leeway to stimulate its economy. And given the indications from some of its leading indicators (such as the PPI, which was down -1.3% YoY), such a stimulus is urgently needed. Additionally, with possibly less-restrictive Covid measures and its dual circulation strategy (greater focus on the domestic market, less reliance on exports), the Chinese economy might once again act as a backstop to Western economies, at least in specific sectors. As a result, we see Chinese growth outpacing other Western countries over the next two years, and  Chinese equities might emerge as the big winners in 2023.

Europe is in a more precarious situation due to its dependence on Russian oil & gas. Europe was able to refill its reserves, and mild weather significantly reduced consumption. But, as of now, any worsening in weather conditions could severely affect the European GDP and its inflation outlook, as high energy prices account for more than one-third of the latest 11.5% inflation number. We believe the market is not correctly discounting a possible stagflation outcome (higher inflation together with a recession), which might unfold in Europe in 2023. With inflation currently above the one in the U.S. and an ECB which has not tightened as aggressively as the FED, a recession in the E.U. would be concurrent with higher interest rates (to fight inflation). A deadly combination for European equities.

To summarize: the U.S. economy is still growing, albeit at a slower pace, Europe is flirting with stagflation, and China is in a deflationary environment. Regarding Central Banks, the FED will keep being aggressive until inflation decreases sharply and the job market deteriorates, the ECB will remain in the "moderate" camp, and the Bank of China could lower interest rates. In a stable environment, the choice is straightforward - buy stocks in countries where interest rates go down and sell those where interest rates go up. Unfortunately, Covid-19 has changed many of the world's dynamics, and we are no more in a typical environment. 

Nevertheless, we believe that growth strategies with exposure to quality-growth companies offer an appealing risk reward at current levels and with the above-depicted macroeconomic scenarios. Additionally, we think it is an excellent time to increase exposure to selected Chinese equities.

Catalysts

• China's easing on its zero-Covid policy. If China were to alleviate its zero-Covid policy, its growth would be higher, helping supply-chain constraints and thus positively impacting inflation around the world. 

• Reshoring and greener economies. As massive CapEx is needed, the reshoring and renewable energy themes substantially impact the EU and US economies. Longer-term, too much capacity to the system is likely to be added, inversing the market forces.

• The FED should stop tightening in Q1-2023. Should Fed Funds rates reach the 5% target during Q1-2023 and core CPI <5% (currently at 6.3%), the tightening cycle from the FED should stop.

Risks

• China/Taiwan tensions. Beijing is speeding up plans for a "reunification". If China invades Taiwan, all bets are off.

• Cold weather in Europe. Energy prices will rocket like they did last Summer if the weather in Europe gets colder for a prolonged time. Higher energy prices would trigger the risks of stagflation.  

• A FED which remains too hawkish. Should the FED remain with its hawkish stance despite taming inflation numbers, its economy could see a more prolonged recession.